Are Earnings Important? Yes, But... Revenues Count For More!

Includes: IXC, XBI, XLV, XLY
by: Joseph L. Shaefer


Too many companies are increasing earnings solely by layoffs and other cost-cutting.

There are a few sectors and industries, however, that are growing revenues.

A company can only "cut" so far; we need to invest in those firms that grow revenues and earnings.

Here are our favorite sectors that do both.

Last month I wrote:

"We have been warning that a 3% - 7% decline would take a lot of pressure off this market. Think of a balloon that is difficult to blow up at first, then becomes easier to inflate the more hot air we blow into it. If we just keep blowing, it will burst. But if we occasionally let a little air escape, and then re-inflate it, the walls have stretched and can better handle the increased volume of air. Well, the market of 2013 definitely had lots of hot air blown into it so a normal correction should be welcomed, not feared."

We chose not to panic but to take advantage of the decline to reallocate into stronger sectors. That has been a good decision thus far. We may or may not be completely out of the woods, of course. The news backdrop is still ugly even without considering Russia, Crimea and Ukraine. Home prices fell in both December and January; the service sector purchasing managers' index fell from 56.7 to 52.7, closer to the "50" level separating expansion from contraction in February; the Chicago Fed's National Business Activity Index (taking into account not just the Chicago area, but the entire nation) fell from a negative number to a bigger negative number as, even greater, did the Dallas and Richmond Fed reporting districts; consumer confidence fell again; unemployment claims were up for the final week of February; and durable goods orders were down.

Not enough to give one pause? Then how about the technical and sentiment side of the market? I subscribe to a truly great technical charting service called InvestorsIntelligence. They have found that one of their best contrary opinion indicators over the years has been the percentage of bullish or bearish financial newsletter writers. When these gurus all tilt to one side of the boat, they tend to be wrong in the aggregate. (Your humble writer excepted, of course!) In the past quarter-century, there have only been 6 occasions when greater than 60% of newsletter writers were bullish and 20% or less were bearish. (The other 20% expect a "correction" or were waffling or were rocking back and forth and muttering to themselves in the corner.) The previous five such excesses didn't end so well, and II's recent reading was similar to that of October 2007, with 61.6% bullish and just 15.2% owning up to being bears.

And this cyclical bull is now a full 5 years old; most last just 4 years or slightly less. If enough investors believe we are whistling past the graveyard, it will become a self-fulfilling prophecy as they stop buying.

Also discouraging from a technical viewpoint is that the blue chips of the Dow are lagging the Nasdaq, the Russell 2000 (small caps), the S&P 500 thus far this year. For a real bull market, we'd like to see the leadership coming from our biggest and best companies, as well, not just social networking stocks and profitless electric car companies.

With all this lined up against the market, is there anything good to say? There is. First of all, March and April, historically, are good market months, rising more often not. Tax refunds put extra money in people's pockets, increasing consumer confidence and the wealth effect. Spring is a time of hope and renewal, stripping the moribund overcoat of winter. And this year, if much of our malaise really was caused by weather, the extra hundreds or thousands saved in heating bills will go to consumer saving, investing or spending. And the comparisons for March and April numbers are likely to be surprisingly good.

Corporate Revenue Versus Corporate Earnings

It isn't on page 1 today, but this issue is far larger and of far more concern to you as an investor than whether Russia gets to steal land and industry from Ukraine until they are forced to return it. Corporate profits, the benchmark most analysts use to evaluate a company's health and growth, are making them very happy.

Here's the problem: a company's earnings can grow by laying off employees, buying back stock, paying less or late for supplies, using cheaper toilet paper in (the employee!) restrooms, or whatever. We need to look at corporate revenue, as well. Very few sectors and companies are actually growing, and we are switching to those sectors.

I am increasingly concerned with the spate of earnings reports that are being lauded as proof that companies are successfully navigating the murky economic waters. As I bore down into the numbers, I find far too many firms that are only increasing earnings because they are eating into the core of their business. If a company is to be called a growth company, it must grow its sales, not just its earnings. Sooner or later you've wrung out all the gains you can achieve by tightening your belt; it needs new business to provide real earnings.

As I look across the spectrum of primary sectors of the economy, I can find only four sectors where enough companies are increasing their top line (sales) to warrant any outsized investment: Energy, Tech, Industrials, and Healthcare. The former three play to our Big Themes for the year:

  • Greater energy independence for North America
  • The Internet of Everything
  • Better manufacturing and factory production outlook as offshored jobs come home.
  • The fourth, Healthcare, has been a constant favorite of ours for years and will continue to be as long as the developed world continues aging and the developing
    world continues to make giant strides in medical access.

With our recent purchases, starting in Q4 2013 and accelerating into our current posture, you can clearly see our bias in favor of companies, industries and whole sectors that are increasing their top line revenues and bringing the results down to the bottom line. I firmly believe that another sector will be a direct beneficiary of
these themes as more jobs are produced and incomes improve, so I am also slowly adding to the Consumer Discretionary sector. More jobs = more money in people's pockets = more spending on things they want but haven't been able to buy when it was a question of paying the heating bill or getting that new $295 TV.

Where the Jobs Are

Before you panic unduly reading about layoffs in some declining industries, please note there are jobs going begging in this country. Always remember there used to be thousands of people employed as blacksmiths, seamstresses, coopers, and scores of other professions that experienced "layoffs" or dramatic change over the years. But those individuals, with training, were simply hired into a different, up-and-coming, industry.

The same is true today. Hundreds of thousands of jobs are being created; more will be generated as more offshore manufacturing comes home, more oil and gas is drilled for and transported, more uses are found for connecting everyday things to the larger-than-the-Web Internet, and more people need healthcare. Job-seekers may have to switch industries and they may have to relocate, but the jobs are there.

For instance, while much of the Midwest, great Lakes and Northeast are projected to create new jobs at the rate of 1-1.5% this year, the West and South are on fire.

Want a job? Be willing to move to the Atlantic South or Out West, where it's the best. Manufacturing is booming (you'll note Tesla's (NASDAQ:TSLA) only four choices for their gigafactory are from Texas westward,) oil and gas drilling are thriving, semiconductor and other hi-tech are locating or relocating and, as people move there to take jobs, the healthcare sector will be hotter there than anywhere else. Maybe even bigger than Florida. (OK, maybe that's a bit of a stretch!)

With all the construction of huge LNG and other refineries and plants along the Gulf Coast yet to come, if you're a skilled worker in construction, you might want to get your application in early (like today.) The best forecasts are that the need for pipe fitters, welders, electricians, crane operators, riggers, instrument technicians and others will grow from about 75,000 to 150,000 over the next couple years. Construction contractors are recruiting workers from all over the country to meet these needs. Can wage inflation be far behind? So if you don't like the clean tech jobs in California, Oregon, Washington, Nevada, Colorado, et al (for one of our themes) how about combining energy and manufacturing (the other two) along the Gulf Coast?

I can't predict the market, only those factors that might make for an exciting market. I can't predict when, but I can do my best to position our clients and subscribers so that they are more invested than not in the right sectors at the best time. Our most recent recommendations dovetail precisely with this thinking.

What We're Buying

Though current events such as the Ukrainian situation right now is terrible from a human rights standpoint and to a lesser extent for how it might affect the markets short term, for you as an investor, its significance and ability to affect your portfolio will pass. What happens with jobs, housing, manufacturing and services, technology,
energy, health care, retail sales, Congress, the Fed, and corporate revenues and earnings will remain, with the latter two likely the most important piece of your portfolio's success or failure. Growth counts. And I believe that betting against American ingenuity, innovation, and workers is a fool's errand. That's why we are buying:

The SPDR Healthcare ETF (NYSEARCA:XLV). I chose this from among many superb healthcare ETFs because I think it covers the waterfront the best and has the highest volume for instant liquidity in what may be troubled times. We don't want to see a bid/ask spread of 15 cents during a fast market when we can own the best and see a 1 cent spread. The fund includes companies from pharmaceuticals, healthcare equipment and supplies, health care providers and services, biotechnology, life sciences tools and services, and health care technology. With an expense of .21%, it's a straightforward play on the key facets of providing health care in America and internationally.

We also bought a health care sub-sector, biotech, via the SPDR S&P Biotech ETF (NYSEARCA:XBI). It's one of the more interesting ways to play the biotechnology revolution.

Looking at its top 5 holdings, you don't see industry leaders Amgen Inc, (NASDAQ:AMGN), Gilead Sciences Inc, (NASDAQ:GILD) and Biogen Idec Inc, (NASDAQ:BIIB) taking up 25-30% of the XBI portfolio. In fact you don't see them at all. XBI is a modified equal-weighted portfolio, modified in that they let profits in this volatile up-and-down sector run. As such it has lots of established but less mature companies - the kind of companies that Big Pharma and Big Bio are looking to buy out when they see progress in a field they are interested in.

I believe we are finally standing on the cusp of a great market for biotech products that will change our lives and reduce our spiraling health care costs; some are here, and more are on the way. As Life Technologies (NASDAQ:LIFE) president Peter Silvester recently noted in regards to DNA sequencing:

"Ten years ago it would've taken a factory full of machines the size of fridge-freezers costing millions of dollars. Now you're talking about doing DNA sequencing on a chip. "The cost is coming down dramatically, and our goal is really to democratize sequencing."

The mapping of the first human genome took 13 years and $3 billion. Five years ago that cost was down to a million. Last year it was down to tens of thousands and now it's down to thousands or possibly hundreds of dollars. We are talking volatility and speculative risk here, but we are also talking potentially unheralded growth in revenue and in profits - and, more importantly, in the quality and extension of human well-being. The dream of targeting a specific drug therapy based upon an individual patient's genetic makeup and lifestyle is now within reach. We believe XBI is a way to participate without individual stock volatility and potential losses of greater magnitude.

iShares Global Energy (NYSEARCA:IXC), on the other hand, is a traditional cap-weighted ETF, but it is global in its holdings and is comprised of integrated oil and gas firms, exploration and production companies, equipment and services companies, pipelines, and refiners, in that order. We select this ETF because it is a low-cost and efficient way to invest in the global energy sector, without assuming too much firm-specific risk and still benefiting from industry successes. In this business, big counts. IXC's got big.

Companies in the energy sector have done well but their stocks haven't. But since we remain bullish on the global economy, we think it's time to once again stake out positions in one of our longest-running success stories.

Finally, we have purchased the Consumer Discretionary Select Sector SPDR (NYSEARCA:XLY), which provides exposure to the kinds of good-sized companies that stand to benefit the most if we are correct and the economies of the world continue their slow but steady recovery. More jobs means more spending, and a huge chunk of that spending will go to the 84 companies represented by this low-expense ETF: retail firms, restaurants, online and traditional media providers, clothing and luxury goods companies, automobile manufacturers, movie studios and theaters, and all sorts of good-time leisure firms.

If we are seeking exposure to the doing-better consumer, both here and in developed and developing markets, I don't think we can do better than to ride along with Amazon, (NASDAQ:AMZN), Disney, (NYSE:DIS), Home Depot, (NYSE:HD), McDonald's (NYSE:MCD), Twenty-First Century Fox Inc, (NASDAQ:FOX), Time Warner Inc, (NYSE:TWX), Nike Inc, (NYSE:NKE) and scores more companies at that same high level of quality.

The Fine Print: As Registered Investment Advisors, we believe it is our responsibility to advise that we do not know your personal financial situation, so the information contained in this communiqué represents the opinions of the staff of Stanford Wealth Management, and should not be construed as personalized investment advice.

Past performance is no guarantee of future results, rather an obvious statement but clearly too often unheeded judging by the number of investors who buy the current #1 mutual fund one year only to watch it plummet the following year.

We encourage you to do your own research on issues we discuss to see if they might be of value in your own investing. We take our responsibility to offer intelligent commentary seriously, but it should not be assumed that investing in any securities we are investing in will always be profitable. We do our best to get it right, and we "eat our own cooking," but we could be wrong, hence our full disclosure as to whether we own or are buying the investments we write about.

Disclosure: I am long XLV, XLY, XBI, IXC. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.