Owner-Oriented Investment Research and Commentary - Have a private comment or question? Email us at commonstocksense@gmail.com

Saturday, July 17, 2010

Psychology Remains Fickle as The Big Bad Wolf Ignores Fundamentals

We're sorry to keep coming back to the economy and general media headlines, yet we can't help but provide our two cents.

We know there's much to worry about and have covered some of this before: weak job market, weak real estate market, uncertainty over government regulation, mounting fiscal debt and deficits, higher taxes that will squeeze citizens and corporations alike, and on, and on, and on.....

With the possible exception of recent regulatory changes, ALL of these concerns aren't new news, but the Market wants to fixate on them at present and countless pundits perpetuate a wall of worry. The shifting sentiment reminds us of something Wilbur Ross said in a Fortune interview back in March (note title: "Mr. Distress is Ready to Buy"):
  • "For example, people suddenly decide Greece is the problem, and whack, the market is down 10%. If weeks from now people decide California is the problem, markets will move again. Everyone has known for over a year that both places are troubled. Why do we care now? How do we know that the problems of Greece or rescuing that country will make a difference in the economic landscape one way or the other?"
Ah, how fickle Market psychology can be. In discussing current conditions with a friend and former colleague who's now an equity analyst at a large corporate pension fund, he reminded us that "no one cares that second quarter results will be good, the market is a discounting mechanism -- everyone is worried about the outlook." Okay, fair point - higher equity valuations depend on a growing stream of forward earnings (more specifically, free cash flow).

Let's explore this further with a simple sampling of earnings headlines from the WSJ. However, before looking at fundamental-oriented headlines, let's look at the current, number three headline (front and center) as of Friday 7:45pm EST:
  • Stocks Tumble as Optimism Fades - A double dose of discouraging numbers from corporate earnings and a consumer-sentiment gauge pushed the Dow down 261.41 points, or 2.5%, to 10097.90.
Now, let's quickly review which companies are cited in this article as posting "discouraging numbers": Bank of America (BAC), Citigroup (C), General Electric (GE), and Google (GOOG).

Alright, despite Citigroup beating earnings expectations, seeing fewer charge-offs, and reducing loss reserves (see this WSJ article), maybe the banks are wrestling with a slow/no growth environment (partially on more stringent, self-imposed lending practices = good thing). Actually sounds pretty positive; could be worse.

As for Bank of America, we'll forget about the following Dow Jones headline from 7:42 am Friday morning:
That said, we understand that new regulatory burdens may take a large bite of revenue and earnings.... NOT so good and possibly a meaningful cost not only on BofA but on Americans at large. On this topic, our friend noted the multiplier effect, as in lower revenue and earnings for an entire economic sector may result in reduced consumption (and investment) by a factor many times over the direct corporate expense. Higher taxes are also a culprit with regard to the multiplier effect.

Next, it's true that GE's revenue was down slightly Y/Y, although we could note that this global conglomerate remains largely a cyclical, industrial company despite owning NBC Universal and GE Capital. THUS, we might expect GE to lag a recovery and investors should focus more on new orders rather than trailing sales figures. In this regard, here's what was relayed in the company's press release:
  • "GE's economic environment continues to improve," GE Chairman and CEO Jeff Immelt said, citing growth in orders, margins and earnings amid other encouraging signs in the quarter. "Equipment orders increased 17%, including 20% growth in the Energy Infrastructure segment and 14% at Technology Infrastructure. Oil & Gas and Healthcare orders were particular bright spots and helped hold total company orders backlog roughly flat, excluding the impact of foreign exchange.
On the conference call, CEO Immelt opened with this (courtesy of SeekingAlpha):
  • Just at the outset, I'd say I think the GE team had a really great quarter. Our environment continues to improve, media buying was strong, rail loadings were positive, revenue passenger miles were positive, losses have declined and credit demand is up, and equipment orders were positive. But we are still cautious in a few areas. We are working through a difficult commercial real estate cycle. After many quarters of decline, demand for electricity finally rebounded in the second quarter and we think that's encouraging. And as many people have written, we think this is a multi-speed recovery. So it's going to – the economy is going to strengthen at different paces around the world.

AND, toward the end of the prepared remarks:

  • We have a very strong balance sheet with consolidated cash of $74 billion. You go down the walk, you see lots of free cash flow, which is a big part of the GE business model. It's just lots of cash available for capital allocation as we look at the year. So we continue to build the cash balance. We are on track for CFOA for the year. And I think the cash story and the balance sheet strengthening story is a very positive story for GE and our investors.

Finally, on the European crisis:

  • As Keith said, we had a lot of chance to talk to people. I would say while governments are adjusting, the companies are partners that we work with across Europe are all continuing to invest. Lot of them has export franchises. And so there just seems to be a little bit of a disconnect between what has to happen broadly from a macro standpoint and where the individual companies are that we are working with. So as Keith said, we just don't see a big systemic issue coming out of Europe given what we see today.

To summarize: (1) flat orders overall, but strong new orders in certain segments and mixed growth across various markets (to be expected as the whole world can't necessarily boom at once), (2) giant cash flow and cash on balance sheet (like the rest of corporate America and PE/VC funds), and (3) scary headlines related to Europe are disconnected from corporate investment/growth plans. All in all, not too bad.

AND, what about Google (GOOG)? We know why the Market was upset: flat Q/Q revenue growth and a bottom-line miss on higher operating expenses. BUT, from a How's the Economy Doing standpoint, let's consider that revenue increased 24% Y/Y -- impressive for any company, especially now -- and that Google is hiring more employees. The company is using it's war chest of cash to fund new initiatives that may well lead to even more jobs and other innovations that spur the economy. As an aside, we tweeted
an interesting perspective from Bill Gurley of Benchmark Capital (click for article) on why Google trades at less than 20 times forward earnings rather than 30 times: it's business model is simply "too good."

WE ALMOST FORGOT: back to that simple sampling of earnings headlines from the WSJ (click to enlarge - also captured Friday evening):

For what it's worth, we include 14 headlines exactly in the order we captured them from the WSJ Friday evening (starting with left column moving to right). Let's split three ways:

  • Positive bias: Gannett (GCI), Schwab (SCHW), Daimler, Sony Ericsson, Europe Earnings, J.P. Morgan (JPM), AMD (AMD), J.B. Hunt (JBHT), Novartis (NVS)
  • Mixed: Mattel (MAT), GE, banks (including J.P. Morgan), IBM (IBM - tbd Monday)
  • Negative bias: none.

Count 'em. Nine positive, several mixed, and zero -- zippo -- in the negative category. We could even add several more positive headlines, including results and raised guidance from WW Grainger (GWW), a company that "offers over 900,000 products and sells almost everything from abrasives to refrigerants to vacuum valves" (as noted in Reuters article - link above).

We understand that Market psychology is a significant factor to the extent that it can influence real economic behavior, but ARE WE MISSING SOMETHING? OR, are the front page headlines somehow fixated on the flavor of the day, week, or month, feeding into the negative frenzy?

One thing is certain: from the above sampling of large companies, we truly don't see "discouraging numbers from corporate earnings." Stable to better results are a positive, in our book.

We know the outlook remains critical, yet ample evidence of current momentum across multiple sectors -- including global transportation/trade that feeds the world economy -- suggests continued growth that should also benefit U.S. companies. More earnings reports next week will provide additional color, possibly providing a life line of support to fickle psychology.

One other topic: we're always amazed why the Market frets so much over a reduction in China's GDP growth to 10% from 11-12%. No matter what the figure was, is, or will be, China has the political drive and balance sheet to keep funding long-tailed projects well into this decade and probably beyond. As this continues, Chinese consumption grows and the country imports more from the U.S., Europe, et al. As our friend says, "China wants to be number one," which -- admittedly -- has positive and potentially negative ramifications for us. Fortunately, we've much to contribute to China's growth engine. What did GE say about China during call Q&A?

  • Jeff Immelt: I showed a chart at EPG on China, which I think really reflects our perspective, which is it’s a extremely big and strategic market. We’ve got a big footprint of about $6 billion and we plan to grow at double-digits, that our strategy will be multifaceted, we will have businesses that will completely grow in a significant way like health care.

Here's the slide from the 5/19/10 Electrical Products Group (EPG) Conference:

Bottom-line from all of the above: to lose sleep and increase blood pressure, focus on the front page. To rest well (or at least easier), focus on fundamental results highlighted on the side/back page. Fundamentals are what matter most and, ultimately, drive the economy and shareholder value.

Happy investing,

Jeffrey Walkenhorst

Disclosure: none.

© 2010 Jeffrey Walkenhorst
Please see important Risk Factors & Disclaimer

No comments:

Post a Comment

Note: Only a member of this blog may post a comment.