Don't Let Visibility Cloud the Picture


By Margaret Popper In their second-quarter earnings announcements, CEOs have stopped peppering their discussion with the words "no visibility," but it doesn't seem to be helping their stock prices much. Some have been bold enough to prophesy the next quarter. When Hewlett-Packard (HWP) CEO Carly Fiorina announced that fiscal third-quarter earnings were three times what analysts had been expecting, she said she anticipated some revenue growth and flat expenses for HP's fiscal fourth quarter. The stock moved up for a day or two on the news but has since settled back to its preannouncement level.

Some CEOs have gone so far as to predict the timing of their industry's earnings recovery. In announcing the second-quarter earnings of Dell Computer (DELL), which met the Street's expectations, CEO Michael Dell said PC sales wouldn't come back until the spring of 2002. The stock price dropped about 20% after this announcement.

THE BIG PICTURE. Given that the market has been starved for earnings guidance the past couple of quarters, any negative nuance in a CEO's earnings outlook can cause the stock price to slide. That's better than when the market was trading on current earnings alone -- a bad habit to get into for a price-setting mechanism that should discount future earnings -- but it still misses the broader picture, such as the improving economic data.

Indeed, the market's microeconomic obsession may well set it up for some positive surprises in the next quarter or two. No bad thing, if investors aren't scared into cash holdings instead of taking advantage of stocks that offer significant value at current prices.

Earnings guidance has limited value, in part because of the politics between executives and the market place. "If you [as a CEO] are deemed to be too optimistic, you're more at risk of being perceived as inept," says John Lonski, chief economist at Moody's Investor Service. "If you're pessimistic, you come across as having been prudent. [In the minds of investors] that's a personality that befits a CEO."

NOTHING NEW. When investors interpret guidance, they need to take the pressures on management into account. "If company guidance is positive, it's infinitely valuable. If it's negative, it's meaningless," says Steven Wieting, a senior economist at Salomon Smith Barney. That's why the market rallies on news like Cisco's (CSCO) on Aug. 24 that it believes the earnings outlook will be better than management previously thought.

Nearly everyone has been negative in the current environment, so CEOs aren't really telling investors anything new if they're being negative.

What has investors' attention now is definitely the earnings outlook, as opposed to valuation, which drove the market in late 2000 and early 2001, or momentum, which drove it from 1999 to mid-2000. At this juncture, even the slightest sign that the earnings outlook has improved can affect a stock's price. "At one earnings conference," recalls Wieting, "an executive smiled in response to a question, and the stock price rose."

History suggests the economy should improve within two to six months

The only problem is that while earnings forecasts may seem like a useful tool in divining the difference between things not getting any worse and things getting better, they may be leading investors astray as they try to call a market bottom. "There is a disconnect between the market's pricing and what the macroeconomic data suggest," says Jay Pelosky, global strategist at Morgan Stanley. "The markets have gone from pricing-in a V-shaped recovery -- as late as July -- to pricing in an economic relapse."

That pretty much ignores the economic news. Over the past four months, the index of leading economic indicators has risen. Historically, if that index rises three consecutive months, the economy recovers within the next two months to six months, points out Pelosky. "The economic indicators are pretty good," agrees Noel DeDora, portfolio manager at San Francisco-based money manager Fremont Investment Advisors. "Inflation is not a factor, interest rates are low, unemployment is still low -- even with the layoffs we've had so far -- and the consumer is continuing to spend."

Another bit of good news, from DeDora's point of view, is that it was really only the tech-heavy Nasdaq that has fallen apart so far in 2001. "The Dow and the [S&P] 500 fell enough to officially be a bear market, but the whole stock market hasn't collapsed like it did in the recession of 1974," she points out.

CONSUMER PRODUCTS STRONG. The market's ongoing propensity to interpret all news through a filter of devastation in the tech sector might make a positive economic spin sound unreasonable. But whole sectors have been doing O.K. "Some sectors never said they had no visibility," observes DeDora. "General Electric (GE) has been doing pretty well earnings-wise, as have consumer products companies like Procter & Gamble (PG) and health-care giants like Kimberly-Clark (KMB). That's because their industries never had a bubble."

When managers of these kinds of companies give guidance, it tends to be about earnings growth, says DeDora. But that doesn't mean investors are rewarding the companies. Of the three mentioned above, the only one with appreciable price gains over recent months has been P&G.

Even the tech sector has some positive earnings news, but it doesn't tend to be the so-called New Economy names. "Old EDS (EDS) is doing just fine, thanks," notes DeDora. "It's a classic systems company and doesn't have the [more fashionable and currently less profitable] mix of hardware and software."

Earnings guidance aside, investors should be thinking about taking advantage of the low stock valuations of solid companies that weren't fortunate enough to ride the downturn unscathed. "By the time you have concrete evidence that the economy is improving, you will already have missed a lot of the upward movement in the stock," says DeDora. "Value investors have to be patient."

DOUBLE-DIGIT GROWTH. The way he sees it, companies have only scratched the surface of the productivity gains they can achieve through investment in technology. With patience, even the telecommunications sector will turn out to be a good bet, figures DeDora. "Bandwidth will eventually be needed, and we'll be back to double-digit growth rates soon enough."

Coming out ahead in this market may mean focusing more on the big picture than getting buy signals from the earnings guidance of pressured CEOs. It's always true, but more so now than ever: Invest where the industry fundamentals are strong, and be ready to hang on. Margaret Popper covers the markets for BW Online


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