Earnings Season Update: Show Me the Revenue!

Published Tue, Nov 8th, 2011   Louis Basenese, Chief Investment Strategist

It’s still Groundhog Day on Wall Street!

You’ll recall that a month ago, I complained about the fact that we keep waking up every morning to the same worries about the debt crisis in Europe and how the situation might undermine investments across the globe.

Sadly, things haven’t changed much.

Even though Greece canned its ill-conceived referendum on the latest bailout – along with its Prime Minister, George Papandreou – attention remains fixated on Europe. Only now, all eyes are focused on Italy’s debt problems.

I’m sticking to my guns, though. Eventually investors are going to be forced to focus on something more concrete – like the earnings reports coming out of corporate America. After all, it’s earnings that ultimately drive share prices.

And since we’re more than halfway through the reporting season, I thought now would be a good time to check in with an update.

In short, it’s a mixed bag. So if you’re looking for new stocks to buy in this market, you need to proceed with caution.

Let me explain…

Profits a Mile High

I’ve rebuffed the notion that our economy is on the verge of another recession too many times to count (see here and here and here and here). But let’s go ahead and add these stats to the evidence pile…

• Based on the 88% of the companies in the S&P 500 Index that have reported results so far, operating earnings are on pace to eclipse the old record of $91.47 set back in 2007 by about $3.50. Sorry, but record profits and economic slowdowns don’t go hand in hand.

• If we expand our stock universe to the 1,500 companies that reported results through last Thursday, we find an earnings “beat rate” of 64.5%. (Recall, the earnings beat rate measures the percentage of companies that best consensus expectations.) That’s well above the readings of about 60% for the last two quarters.

Cleary, corporate profits are piling up, which bodes well for stock prices. As a matter of fact, I told you last month that an earnings beat rate of 65% (or better) is particularly bullish. And we’re right on the cusp of that level.

But don’t rush to rejoice or load up your portfolio with any old stock just yet…

Forget the Beef, Where’s the Revenue?

As we all know, earnings can be inflated by cutting costs, boosting productivity, or using aggressive accounting.

To ensure there’s no tomfoolery going on – and that the profit increases are legit and more importantly, sustainable – we need to make sure demand is increasing, too. And the best way to measure overall demand is to look at top-line sales.

Unfortunately, the revenue beat rate for the current quarter – the percentage of companies reporting stronger-than-expected sales – isn’t as strong as the earnings beat rate.

According to Bespoke Investment Group, only 62% of companies have beat revenue expectations this quarter. That’s the lowest level since the bull market began in 2009.

While it’s possible for the final revenue beat rate to check in higher once all companies have reported third-quarter results, I suggest you proceed with caution.

We may no longer be in a rising tide market. In other words, going forward, the only boats (i.e. – stocks) getting lifted will be the ones with the best fundamentals.

Practically speaking, if you’re looking to make new investments in this market, I suggest you focus on “triple play” companies – ones that beat both earnings and sales estimates and also raise guidance.

“Typically less than 5% of stocks during any given earnings season will report triple plays,” says Bespoke Investment Group. So far this season, only 83 companies have pulled off this rare feat.

Three that I think look like particularly compelling investments are regional electronics retailer, hhgregg (NYSE: HGG); bakery-café operator, Panera Bread Co. (Nasdaq: PNRA); and a data storage technology company I recommended yesterday in The White Cap Report.

(In fairness to White Cap subscribers, I can’t reveal the name here. But all you have to do to find out the name of the company is sign-up for a free trial subscription.)

Bottom line: The latest earnings season stats suggest it’s time to adopt a rifle, instead of a shotgun, approach. Insist on companies with the strongest fundamentals. Specifically, ones reporting higher-than-expected sales and profits and raising estimates for future growth.

Ahead of the tape,