In the just completed third-quarter earnings season, results came in significantly above expectations. In fact, we made a new record for positive surprises. The year-over-year comparisons were not that flattering however, reflecting the impact of the economic downturn on corporate results. While it will be difficult to improve upon the third quarter's record outperformance, the overall positive trend should largely remain in place.
It is very tough to make accurate forecasts at turning points in the economy. It's difficult to size up corporate profitability when the economy is going into a recession or coming out of one. The third quarter of 2009 was one such turning point - we came out of the recession towards the end of summer.
While I am not discounting the corporate world's proven ability to manage earnings expectations, the inherent difficulty of making earnings estimates at such economic inflection points also needs to be appreciated.
But we are out of the recession now and, to that extent, earnings estimates will better reflect the macro backdrop. Positive estimate revisions of the last few weeks represent these changing expectations. Given these reasons, it is fair to assume that the number of companies coming ahead of expectations in the next earnings season will be below the third quarter's level. The most likely scenario is that we will get back to the historical average of about two-thirds of the companies beating expectations.
I am positive about corporate earnings in the next quarter and year. Earnings should be helped in coming quarters by an improving domestic economic scene, robust growth internationally, especially in emerging markets, favorable exchange rates, and easy comparisons.
We have heard a lot about the lack of top-line growth in the third quarter, but all may not be bad on that front either. We did see sequential improvement in the top line (the third quarter better than the second quarter), which may be indicative of a turnaround. Given how lean the operating structures have become after stringent cost cuts over the last few quarters, even modest top-line improvements will have major impact on margins and earnings. And don't forget that the dollar's slide is also beneficial to earnings. All in all, the worst may already be behind us on the earnings front.
Portfolio Updates
Cisco Systems (CSCO) was added to the Focus List last week. This worldwide developer and manufacturer of networking and software technologies comes into the portfolio with some very nice upward momentum. It recently reported strong third-quarter earnings of 30 cents, 4 cents ahead of the Zacks Consensus Estimate. The company has beat in each of the last four quarters by an average of 3 cents, or 11%.
The Zacks Consensus Estimates have also been on the upswing, with the current year adding 10 cents in the last month and moving to $1.25 per share. The next-year estimate is pegged at $1.44, a bullish 15% growth projection.
Cisco has attractive valuations, trading at 19.5x forward earnings. We like the large cap technology space at this juncture of the recovery.
A Focus List Deletion
Dresser-Rand Group (DRC) was removed from the Focus List on Nov 11. The fourth-quarter Zacks Consensus Estimate had been falling as a majority of the covering analysts cut over the last month. Estimates were also being cut for the first quarter of 2010, and the full-year 2010 estimate also weakened. Given the estimate cuts, we decided to exit our position.
Zacks Investment Research
