Halftime Report: Fourth-Quarter Earnings Season

Submitted by Wall St. Daily as part of our contributors program

Yesterday, I shared why the Fed is ultimately the one mashing the gas pedal to drive stock prices higher. (Scary thought, huh?)

Well, the good news is that the fate of our hard-earned capital isn’t resting entirely in Ben Bernanke’s hands.

Even if he eases up on the quantitative easing (QE) efforts, underlying company fundamentals support higher prices still.

Here’s proof…

So Far, So Good

The end of last week marked the end of this year’s professional football season. (Pass the Kleenex, please.) But it also marked the halfway point for the fourth-quarter earnings-reporting season, which is a tad more important.

You’ll recall, on January 10, I told you to keep an eye on three key earnings metrics that can predict the trajectory of stock prices in the weeks and months ahead.

So let’s check in on the latest readings…

~Key Metric #1: Earnings “Beat Rate”

I told you that the earnings bar was set extremely low heading into this reporting season. And that’s proven to be true.

Case in point: 63.1% of companies beat earnings estimates so far, according to Bespoke Investment Group. If the reporting season ended today, that would be the best earnings “beat rate” in nine quarters.

Remember, I also predicted that “any reading above last quarter’s 60.1% should be enough to propel stock prices higher.” And sure enough, the S&P 500 Index is up 3.7% since Alcoa (AA) officially kicked off the reporting season.

It’s worth noting that Bespoke bases its calculations on a much broader universe of U.S. stocks. But if we limit our analysis to just the S&P 500 companies, we get a similar picture of strength.

FactSet’s latest Earnings Insight report reveals that of the 234 companies in the S&P 500 that already reported results, 70% topped expectations. That’s better than the average beat rate over the last four quarters, which is 69%.

~Key Metric #2: Revenue “Beat Rate”

While earnings can be manipulated, sales cannot. This makes revenue a more reliable indicator of demand. And based on current sales data, demand is stronger than expected, too.

At the halfway mark, the revenue “beat rate” – the percentage of companies topping sales expectations – stands at 62.2%, according to Bespoke. That’s a dramatic increase from last quarter’s reading of 48.2%.

Once again, FactSet’s calculations confirm the strength. It estimates that 67% of S&P 500 companies topped sales expectations so far. And that’s head and shoulders above the 50% average of the last four quarters.

~Key Metric #3: Guidance Spread

While companies aren’t required to provide future guidance, enough do. So I’ve long contested that it’s worthwhile to track this statistic. I’m second-guessing that assertion now, though. Here’s why…

For the last five quarters, the guidance spread – the difference between the percentage of companies raising guidance and those lowering guidance – has been negative.

And although Bespoke hasn’t updated its calculations recently, FactSet’s report reveals that we’re most likely in store for another negative reading this quarter.

So far, 50 companies in the S&P 500 have issued negative guidance. Meanwhile, only 11 have issued positive guidance.

Add it all up, and I think corporate executives that provide guidance are attempting to game the system. They’re constantly under-promising – just so they can over-deliver.

And there’s definitely an incentive to do so.

Consider: Going into this quarter, expectations were extremely low. Yet most companies beat expectations. The end result? Stock prices are up an average of 0.77% on the day of their earnings report, according to Bespoke. That’s the best one-day average gain in eight quarters.

In other words, the whole under-promise, over-deliver tactic ultimately helps drive share prices higher. I’ll take it for now. But in future quarters, we might revisit the importance of the guidance spread metric. Stay tuned.

Translating the Data into Strategy

Now, before someone quips that all these metrics are meaningless unless we can use them to identify new opportunities, let me do just that…

It stands to reason that “triple plays” – companies beating earnings expectations, beating revenue expectations and raising guidance – are the most fundamentally solid – and, therefore, the most investment worthy.

And if we focus on sectors with the highest beat rates, too, we should be able to increase our odds of investment success even more. After all, high beat rates indicate that the sector is benefiting from some type of tailwind. Otherwise, companies would be missing expectations, not beating them.

With all this in mind, we should be focusing on the technology and healthcare sectors right now, as they sport the highest earnings and revenue beat rates this quarter.

In terms of specific opportunities, here are two technology triple plays to consider:

• Synaptics (SYNA)
• Super Micro Computer (SMCI)

And here are two healthcare triple plays to consider:

• Qiagen NV (QGEN)
• Covidien (COV)

As always, I recommend that you perform your own due diligence before investing in any of them. And “you’re welcome” for narrowing the universe of thousands of stocks to choose from, down to only a handful.

Bottom line: There’s not a soul on Earth predicting that Ben Bernanke is going to slam on the brakes by ending QE efforts and simultaneously raising interest rates. So we can reasonably expect the bull market to continue, given the underlying momentum in corporate fundamentals.

That being said, don’t buy blindly. Instead, invest in sectors and companies putting up the strongest results. Or, more simply, remember that the trend is your friend