Questions about accounting and the strength of the economic recovery are clouding the corporate earnings outlook, according to Charles L. Hill, director of research for First Call's Quantitative Services Div. Hill, an earnings experts, thinks some of the forecasts of second-half profits this year are overly optimistic, especially in the technology sector.
He also sees post-Enron concerns about accounting, related changes in the rules, and in corporate reporting as a drag on earnings. But he strongly supports the need for more disclosure and the elimination of conflicts of interest among both accountants and analysts.
These were some of the points Hill made in a chat presented Apr. 25 by BusinessWeek Online on America Online in response to questions from the audience and from Jack Dierdorff of BW Online. A complete transcript of this chat is available from BusinessWeek Online on AOL, keyword: BW Talk.
Q: What are the chances for an end to this downward drift?
A: Three things are weighing on the market right now: the situation in the Mideast, Enronitis, and concerns about sustainability of recovery in the second half of this year. The first-quarter reports -- and comments with them from management -- have been reasonably good. We believe earnings estimates for the second quarter are very realistic, but the very ambitious third- and fourth-quarter estimates may not be attainable. The problem is that this is a different kind of recession. The bounceback in tech and telecom is where much of this growth so far was supposed to come from -- and we haven't seen that yet.
Q: Would you care to comment on the feds' move to make analysts more responsible?
A: Well, it's not really the feds as much as the Securities & Exchange Commission and the New York State Attorney General. We're seeing some important new standards that they're trying to implement. I believe the SEC will issue some reforms on May 8 that can be divided into three categories: One is the problem with recommendations. Second is the analyst's holdings and the ties with investment-banking relationships. And the third is the belief that many analysts were compensated [according to the] volume of investment banking that their work brought into the firm.
As we characterized it in the past, the investor has needed a two-level decoder: One compares all the analysts' recommendations with one another. The second level of decoder was to essentially offset the often optimistic "buy" recommendations of the analysts. The new rules allow for recommendations, but the analyst must spell out whether [a stock] is a buy, hold, or sell. Also, cases where companies have investment-banking clients whose stocks are also covered by analysts [must be disclosed under the new rules].
While these are good moves, I don't think they go far enough.... Eventually, something needs to be done about the compensation conflict.
Q: Based on earnings reports -- and prospects -- what sectors or industries look best right now?
A: Analysts' expectations by far are greatest for tech.... For the Standard & Poor's tech sector, which consists of 84 companies, expectations for the first quarter are for earnings to be down 30%, with 59 of those companies already reported. But then in the second quarter, the analysts expect a huge swing in tech, up 334% from last year. That's probably realistic. Their expectations in the third quarter are for earnings to be up 136% and then up 73% in the fourth.
The next-biggest growth area would be the basic materials -- papers, metals, chemicals. While they're expected to be down 15% in the first quarter, they're expected to be up 13% in the second, 53% in the third, and 172% in the fourth.
Q: Do you think the estimates for tech have a chance of coming true and justifying people betting on tech stocks?
A: No. We're very concerned about the expectations in the tech sector. The two main driving forces for tech-sector earnings are capital spending and the new-product cycle. We're clearly in the mediocre phase of the new-product cycle.... The only area where there is really new-product stimulus is in video games, and that's a pretty small area.
Regarding capital spending, this is a very different kind of recession compared to past recessions. Like the others, there's the potential for a big rebound in capital spending, but since this recession was caused by [a hangover after] a capital-spending binge, the recovery may be more gradual than past ones. Unfortunately, many analysts may be using those recent recoveries as a guideline for this recession and how it plays out. And we think that's misguided. We see big questions about the main drivers for tech earnings.
And on top of that, you have the impact of Enronitis. There's no question there will be a drag on corporate earnings as companies are less aggressive in pushing the accounting. Auditors hopefully will be more vigilant. Analysts will hopefully be more discerning. And since the greatest excesses were in the tech sector, it will [have more than a negligible effect on] the tech sector and tech earnings.
Q: I've heard it said the accounting medicine that companies are taking may depress the market now, but will give their stocks new vigor sooner or later. Do you agree?
A: Yes. But "later" may be a couple of quarters or so off. Obviously, the new rules will be the first step, but investors will want to see if they really work.
Q: How do you see earnings in the energy sector, with the Mideast in mind?
A: Energy earnings will be down about 67% in the first quarter and down 42% in the second -- and only be down 15% in the third quarter, then up 54% in the fourth. Bear in mind that's going on tough comparisons [with] the beginning of 2001 to the very weak fourth quarter of last year.
Given the current situation, obviously the analysts' projections for the third and fourth quarters are way out there. There's a good chance that prices could stay up at reasonable levels. [Even] if there was a cutoff on oil, I think the analysts don't see it going up to the very high levels they did before, with the increased production from Russia.
Q: How about results for banks and other financial companies? Credit quality is down, and interest rate hikes are looming.
A: Well, that doesn't seem to faze the analysts. They expect 5% earnings gains in the first quarter, 22% in the second, 47% in the third, and 43% in the fourth.
Q: I know you don't make specific recommendations, but could you suggest the stance a long-term investor should take now? And where to look for the best results?
A: What a question to end on! I would certainly recommend sticking for at least the next year with companies that have the transparency or disclosure that investors would like to see. We'll probably be in the mode of punishing those with questionable accounting practices or earnings disappointments and not rewarding upside surprises if there isn't a full understanding of where [they're] coming from.