April 17, 2003
Wall Street Misses the Point on EPS
On Tuesday TheStreet’s Aaron Task wrote an article entitled “Small Gain for Stocks, Big Hit to Bear Case”. He went on to say “Those market participants skeptical about the sustainability of Monday's advance got a rude awakening Tuesday.”
Mr. Task’s knack for hyperbole notwithstanding, only a complete and utter buffoon would argue that the ‘bear case’ is grounded on the day to day movement in the stock markets. After all, the Nasdaq rallied by 85% in 1999 and bears were not ‘rudely awakened’ by staying away from tech, but enlightened…
Regardless, what Mr. Task and many others pointed out on Monday and Tuesday is that the major averages (Dow, S&P 500) were back above their 200 DMAs, and that tech stocks were gaining a bubble type aura (tech company ABC beats EPS estimates by a penny so all tech stocks rally). Given that bullish momentum took a break yesterday - both the Dow and S&P 500 closed below their 200 DMAs – does this mean the bulls have been ‘rudely awakened’?
CNN’s lead story this morning is “Nokia's results could lift the markets” and a moronic Street headline reads ‘AMD's Revenue and Loss Both Better Than Expected’. Suffice it to say, before the bulls can be rudely awakened they must first wake up.
Earnings Not Bad…Valuations Not Good
As the MBAA’s Jay Brinkmann notes, “Consumers took out a record $537 billion in new home loans last quarter, making it the strongest quarter for mortgage refinancings ever.” With this in mind, it is not surprising that a handful of banks continue to ride on the back of the U.S. consumer (banks reported respectable earnings compared to the estimates to kick of this week). Not to be left out, GM (GMAC) reported better than expected results primarily because earnings from mortgage lending doubled.
However, positive earnings results have not bee quarantined to financial stocks. Rather, tech companies – including Microsoft, Intel, and Nokia – have been able to satisfy analysts and investors despite their hazy outlooks, and companies like Ford have sharply beaten estimates and posted strong stock market gains.
That said, while earnings have been slightly positive compared to the crafted estimates, they have not been strong enough to suggest that forward looking valuations are being underestimated. In other words, the markets remain rich, and no evidence has surfaced to suggest that the dramatic surge in profits will arrive (as expected) in the latter half of 2003.
As for the boost in consumer confidence following the demise of Saddam’s regime, there is no evidence (yet) that this increase in confidence is translating into increased spending. In fact, GM reported yesterday that sales for April – even with the war largely over, consumer confidence rising, and incentives galore – have not been as strong as expected. Nevertheless, the word yet should be remembered – when you combine the drop-off in energy prices with a decrease in geopolitical uncertainty, this should lead to an increase in consumer spending.
As for tech valuations, most companies still trade at absurd premiums. For example, Intel reported a decline in both earnings and revenues on a year-over-year basis, and provided an uncertain outlook (flat 2Q03 sales). Yet Intel currently trades at 30 times Dec 03 earnings estimates and 23 times 2004 estimates. Why pay 23 times 2004 earnings for a company that is not growing?
Rather than point out all the Intel’s – companies that are reporting no growth in earnings but for some reason are expected to grow earnings by 16% in each of the next 5-years (your basic absurd overvaluation) – a company like Microsoft serves as a better example of basic overvaluation.
MSFT Versus ATR
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ATR is more attractive based upon all of the basic valuation tests bolded above. In fact, given that ATR just reported a 21% increase in revenues and a 44% jump in EPS – while Microsoft only managed to increase in revenues by 8% and EPS by 2% -- the case could be made that the forward earnings estimates are out of whack. In other words, it is possible that MSFT’s 5-year earnings estimates are overly optimistic while ATR’s are more realistic (both companies would perform well during a strong economic recovery but unless there is a tech mania recovery ATR may be more likely to mirror consumer spending habits).
To be fair, on a free cash flow basis (cash from operations minus expenditures) both ATR and MSFT are currently trading at 17 times free cash flow. And while comparing free cash flow levels between two companies in different industries is riddled with flaws (each industry has its own cyclical trends and capital expenditure requirements differ from industry to industry), MSFT’s cash flows are more respectable than its inflated earnings multiples.
In short, investors are willing to pay a greater premium to that of assets and earnings for MSFT than for ATR because MSFT is a big, lovable tech stock that generates free cash (and has a tiny dividend). Point being, MSFT’s richer premiums – in particular its PEG ratio – are based upon exceptionally optimistic growth expectations, whereas ATR is grounded on more realistic expectations. I use the term ‘realistic’ because ATRs stock price is trading at a respectable multiple (16) while MSFT’s is high (28). Should both companies meet expectations, and continue paying dividends, only one company deserves to trade higher based upon rational valuation considerations (ATR)…
EPS Games
Since the earnings season has not had a series of disastrous reports/forecasts investors have become more complacent (declining VIX); apparently investors believe that the markets will exit earnings season without suffering a serious decline so long as the post-war economy continues to show improvement.
Be aware: although it is difficult to argue that 1Q03 earnings will justify a stock market advance, like so many rallies before the current rally could last longer than most expect. Quite frankly, ‘the worst is over’ is a powerful mantra that can unleash gains in the markets for no other reason than misplaced investor hope.
That said, until (and if) the markets can recapture some basic technical levels investor excitement appears to be caged – no one is willing to make a big bet on the markets direction. As such, the only thing for certain is that when someone uses the term ‘better than expected’ – as if to suggest that AMD’s pathetic financial losses are somehow forecasting a better tomorrow – they are doing so because this earnings season is like all the rest: a time when Wall Street babbles on about EPS hits and misses but misses the larger point.
That point being, the S&P 500 is trading at nearly 30 times historically manipulated earnings.
On a final note, CBS Marketwatch reads ‘Nokia counters U.S. job data’ this morning (suggesting that Nokia’s 1Q03 earnings – to say nothing Nokia’s 2Q03 warning – is allowing investors to buy stocks and ignore a sharp spike in jobless claims). You don’t try to make sense of this type of commentary. Rather, you simply remember the number 30 and realize that the mania is alive and well.
The 1982 bull market began with the number 8...
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