By Joseph Hogue
Third quarter earnings have begun to come in, and an end to the five-quarter earnings recession for companies in the S&P 500 isn't likely.
Investors have continued to bid up stocks on the hope that earnings could rebound this quarter and that higher profits would overcome the wave of geopolitical and economic hurdles facing the market.
But can the market continue higher without an earnings turnaround? If revenue and profits fail to grow as expected, how long can investors rationalize valuations well above historical averages?
I'm always looking for quality names and value, but put my search into overtime when I start asking these questions. If the market fails to get all it wanted out of earnings season, companies that have proven their business models through good times and bad may be the only safe investments in the ensuing selloff.
Can The Market Break Its Earnings Recession?
Alcoa (NYSE:AA) shocked the market last Tuesday missing on both sales and earnings, as questions arise about whether companies in the S&P 500 can break their long-running earnings drought. The miss sent shares tumbling more than 11%, while the S&P 500 fell by 1.25%, for its biggest daily drop in a month.
Aggregate earnings at companies in the S&P 500 index are now down 18% from the peak of $105.96 in September 2014. That kind of an earnings decline would normally be all the reason needed to push prices lower, but low rates and the promise of a return to earnings growth have supported stocks higher.
Until Tuesday, it looked like companies would be able to beat the earnings recession.
S&P 500 companies have beaten earnings estimates by an average of 4.3% over the last four years. That would seem to imply that the forecast for a 2.1% decline in Q3 earnings could end up being the first quarter in six to see positive profits. That hope has supported high stock prices and a market that is shrugging off the potential for higher interest rates.
Alcoa's wide miss and warnings by others called all that into question last week. Sluggish economic growth is hitting corporate America on the top line as well, with six consecutive quarters of declining revenue through the second quarter. Analysts expect S&P 500 companies to break the trend with sales growth of 2.6% this quarter.
Quality Companies That Can Survive In Any Environment
In this kind of earnings drought, I'm looking for quality names that can hold up in any environment. I'm looking for companies that have proven they can grow sales and earnings even during a recession.
I started with a screen of companies with positive earnings and sales growth in every year over the last decade. I also don't want to pay too much of a premium for these quality names, so I added a value measure to the screen. The result was 32 stocks in the Morningstar universe.
I've narrowed it down to just three that have strong upside price potential and healthy financial records.
Tractor Supply Company (TSCO) is the largest retail farm and ranch store operator in the United States, with more than 1,500 stores in 49 states. Much of the company's product base including livestock products, hardware, tools and maintenance products are expensive to ship or benefit from an immediate need, insulating Tractor Supply from the e-commerce threat. Tractor Supply's all-U.S. exposure means it won't be subjected to the weakening international earnings picture hitting other companies. The company opened an Arizona distribution center late last year to service regional business, which should help it to manage inventory more efficiently and cut costs.
Shares trade for 21.9 times trailing earnings versus an average multiple of 28.3 times over the last five years. Earnings are expected higher by 10.6% over the next four quarters to $3.45 per share, for a price target of $97.63 per share.
The Priceline Group (PCLN) operates the world's largest online travel agency across a network of websites that gives it scale advantages in bookings and vacation packages. The company easily beat expectations in the second quarter with 19% year-over-year growth in bookings and 24% growth in room nights, both double the percentage growth at rival Expedia (NASDAQ:EXPE) during the quarter. The company's increasing dominance gives it the advantage in negotiating rates with hotels and service providers.
Shares trade for 27.9 times trailing earnings versus an average multiple of 30.5 times over the last five years. Earnings are expected higher by 16.2% over the next four quarters to $72.50 per share, for a price target of $2,211 per share.
Cognizant Technology Solutions (CTSH) is a global IT outsourcing services firm, though it books 78% of its revenue in North America. The company has been able to maintain a client retention rate above 90% through its unique model of basing a third of its project team at the client's site. This makes for strong customer relationships and a better understanding of local business. Shares were rocked late September when the company announced an internal investigation into payments to Indian facilities and a possible breach of the Foreign Corrupt Practices Act (FCPA). Even if the company is made to pay for FCPA violations, shares are down 28% since the 2015 high and may already reflect a fine.
Shares trade for 20.1 times trailing earnings versus an average multiple of 24.0 times over the last five years. Earnings are expected higher by 8.0% over the next four quarters to $3.49 per share, for a price target of $83.76 per share.
Risks To Consider: A hard hit to investor sentiment on weak earnings could hit shares of even the strongest companies. These quality names should stand up to the test but may still weaken.
Take a position in companies that have proven their earnings power over time and offer attractive valuations in an inflated market.
This article was originally posted on StreetAuthority.com.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
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.