Five Stock Ideas in Two Sectors with the Best Outlook

With data from 448 firms through last Friday, Zacks has released an update on second-quarter earnings.

Total earnings fell 32% from 2008 levels, but positive earnings surprises saved the day. There were 3.3 positive surprises for every negative surprise, and this has been fueling the market's latest rally (until this week).

Cost-Cutting Gets Results, For Now

The bad news is that companies met estimates by cutting costs. Margins rose throughout the S&P 500, but sales were disappointing. Of the 448 firms that have reported through last Friday, total sales fell by 17%. Overall, only 24% of companies had sales that were higher than 2008 levels.

I have argued that the market is ignoring bearish sales signals, and this is born out by the data. I also believe that the proliferation of momentum trading systems may be contributing to the recent rally, since quant models are getting a false signal from recent earnings "surprises." A quantitative model is only as good as its data feeds, and poor earnings quality is exaggerating the number and magnitude of second-quarter earnings surprises.

Positive Revisions Go AWOL

We've had a blizzard of positive earnings surprises, so you'd expect a similar blizzard of positive earnings revisions as analysts adjust their spreadsheets. Alas, we have just a few flurries of positive revisions. Over the last four weeks there have been 4,253 revisions in total, of which 28% are positive and 19% are negative. That is NOT a bullish ratio. In fact, considering the enormous quantity of positive earnings surprises, the revisions are awful.

Rally Has No Legs

Cost-cutting only goes so far, and it certainly doesn't help the employment outlook. This explains why analysts are hesitating to raise estimates: Companies are already lean and mean, and further cost-cutting might be counterproductive. Right now, we are in a liquidity boom, fed by easy money and huge deficits, so the natural trend is up. We have minimal price pressure, too, since corporate cost-cutting and deleveraging by banks and consumers is causing temporary deflation. Growth without inflation is the best of all worlds, but inflation relief won't last: Fiscal excess is notoriously difficult to unwind, so today's counter-cyclical spending becomes tomorrow's entrenched deficit.

Defensive Sectors Still Look Best

The Healthcare and Consumer Staples sectors had the best quarters in terms of earnings surprises, and they also have the best outlook based on earnings revisions. Healthcare has had a remarkable 8:1 ratio of positive earnings surprises vs. negative earnings surprises, while Consumer Staples had a 4:1 ratio. Looking ahead, both sectors have had a 3:1 ratio of positive earnings revisions vs. negative earnings revisions. Evidently, analysts believe that the postive earnings surprises in the Health Care and Staples sectors are a genuinely bullish sign.

Three Healthcare Ideas

Since I believe that the reflation rally is due for a pause, defensive names make sense. Zacks likes the following in Healthcare:

• McKesson (MCK): Drug distribution, healthcare software and consulting. Forward P/E of 12.8x and positive sales growth. Stock is $4 below overhead resistance at $59. This idea makes sense to me as a play on 3Q earnings.
• Amgen (AMGN): Top biotech firm and maker of Epogen, Neupogen; approval of billion-$-drug Denosumab pending in October. Weak revenue in first quarter as safety concerns hurt sales of anemia drugs, but firm raised sales guidance in July. Selling at 12x forward earnings. At $65, stock is now testing September high of $66. I like the bullish sales guidance, though drug approvals are anyone's guess.
• Intuitive Surgical (ISRG): Makes "da Vinci Surgical System" for minimally invasive surgery. Sells for 27x forward earnings, and stock has more than doubled since March lows. The recession seems to have hurt sales for their innovative, $1-million+ systems. The stock should rise if EPS surprise on the upside, as Zacks predicts.

As with all earnings momentum strategies, it makes sense to take small positions and to use a stop loss. These trade ideas have a three-month timeframe, so I would use a stop-loss based on the last six months of volatility. If I were really ambitious, I'd take a peek at implied volatility from the listed options for anything squirrely. Amgen, for example, is sitting on a major drug approval, making the stock unusually volatile. Success or failure will swamp any earnings news, making this trade idea weaker than the other two.

No Cigarettes for Me

Consumer Staples is also defensive, and Zacks likes Altria (MO) and Reynolds America (RAI) for those who are comfortable with tobacco (I'm not). Better yet, you could buy both Altria and Intuitive Surgical, so you can profit from both cigarettes and the minimally-invasive surgical cure.

Disclosure: No position in stocks mentioned.

Comments

[Temperance:]

ISRG: don't forget about the potential for a large revenue source from their exclusive rights to over 600 U.S. and foreign patents. Royalties are a very good thing.

Aug 12 01:13 PM

[Robert Mart...:]

Temperance:
Patent royalties ARE a very good thing, as are the "razor and razor-blade" revenue stream from the da Vinci Surgical Systems.
Rob

Aug 12 03:06 PM

[fcharlie:]

Zacks has a sell rating on Altria. Why is it that Seeking Alpha is so full of incorrect information?

Aug 12 04:21 PM

[Robert Mart...:]

fcharlie:
Altria was downgraded today to a "Hold". I published this article before the downgrade from Zacks.

Thanks for highlighting this.

Aug 12 07:03 PM

[Jake2:]

Suspcious of Zacks. Don't ask me why. Due diligence is the word. I.e., do your own research and come to your own conclusions. Seek two sources for every rubric.

Aug 13 01:13 AM

[Robert Mart...:]

Jake2:
Zacks is a tool for screening earnings momentum, nothing more. As you noted, we all have to do our own due diligence.
The problem with using third-party screens is that you don't see downgrades and upgrades coming. Zacks downgraded Altria on the day I published this, making me look foolish.

You place your bets, and you take your chances...

Thanks,
Rob


On Aug 13 01:13 AM Jake2 wrote:

> Suspcious of Zacks. Don't ask me why. Due diligence is the word.
> I.e., do your own research and come to your own conclusions. Seek
> two sources for every rubric.

Aug 13 12:47 PM