Is Annual Guidance a Reasonable Expectation for Investors?

Regular readers of this blog are aware that I think public companies giving out quarterly earnings guidance is something that should be eliminated in order to ensure that management teams run their businesses for the long term, not with a goal of “hitting the quarter” any way possible.

It is also fairly unreasonable to expect a CFO to be able to predict whether certain expected revenue will be booked in June or July several months in advance. It can make all the difference in the world in trying to meet or exceed previously issued guidance on a three-month basis, but should investors really care if a big order is shipped on June 25th or July 5th? I tend to think not.

Fortunately, many companies have ceased issuing quarterly guidance. Some, however, are taking this practice a step further by halting annual guidance as well. I was listening in on the Affiliated Computer Services (ACS) quarterly conference call yesterday afternoon, and they announced that they will no longer provide revenue or earnings guidance on an annual basis. ACS’s 2007 fiscal year began in July, so investors looking to get some sort of idea of how the next year will shape up are at a loss.

So, this brings us to an important point. Should investors be upset if they aren’t provided annual guidance? I tend to say “yes.” Forecasting an entire year (without breaking it down by month, quarter, or even half) shouldn’t be as difficult and unproductive as issuing quarterly guidance. I don’t care if some business gets pushed into Q2 from Q1 at the last second, but I still want to have some idea of how 2007 is going to look compared with 2006.

If I don’t have any idea how fast a company will grow its earnings, how can I assign the stock a multiple that I think represents fair value? It makes life awfully difficult. Just give us a range of, say 5%, for forward annual growth. If ACS says 2007 growth in earnings will be 5%-10%, I have an idea of how much to pay for the stock. If I don’t know if growth is expected to be 0% or 15%, the fair value ranges I could come up with become so wide they are fairly useless.


So Far, So Good on the Earnings Front

We still have a lot of reports to come, but so far second quarter profit reports have once again come in very strong. Aside from the obvious, a fairly strong economy, I think there are two key reasons why we are seeing strong corporate results.

The first is clean corporate balance sheets. Public companies are flush with cash which gives them a lot of flexibility in managing their business. Excess cash has been used for acquisitions as well as share repurchases quite heavily in recent quarters. M&A can be very accretive if done right, and buyback programs can add a penny or two to the bottom line in any given quarter.

The second reason earnings have been so strong, in my opinion, is because managements have finally figured out that the key is to under-promise and over-deliver. This is true in any business, public or private. However, in the go-go days of the late 1990’s, stocks would only rise if the firms beat numbers and raised guidance every three months. CEOs had to be overly optimistic in everything they said in order to prop up their already richly valued stocks. As a result, expectations got way out of line and eventually the bar had to be ratcheted downward.

I think today is different. The trend has been to beat numbers and issue cautious guidance. This serves to hurt share prices right after results are released, but it brings expectations down for future quarters. Then, the company beats the reduced expectations the next quarter and again issues cautious guidance. The cycle simply repeats itself over and over again. Executives have finally figured out that hyping their company’s future prospects can end badly if they fail to deliver on the lofty promises.

Readers of this blog know that I’d prefer companies shun quarterly guidance completely. However, if they insist on giving out financial projections every three months, at least most are setting the bar low enough that they can at least hit, and often even surpass, their projections.


Will Earnings Help Alleviate the Geopolitical Selling?

Geopolitical concerns always spook the markets short term, but longer term investors most likely shouldn’t panic by making bold changes to their overall investment strategy. The situation overseas can change nearly overnight in some cases, and history shows that lost ground due to panic selling is often made up within several weeks or months.

After a nice rally off the June lows (around 1,225 on the S&P 500) it appears we will retest those lows, which would not be a bad thing. Rather than try and predict what will happen in the Middle East, I will instead be focusing on Q2 earnings reports. The three or four dozen companies I follow begin reporting on Monday. Recent stock price action suggests the numbers will be weak, but I am not convinced quite yet that will be the case, despite the negative reports thus far from the likes of Advanced Micro Devices, 3M, EMC, and Alcoa.

If we look back three months ago, I was pleasantly surprised by how well the companies I owned did. Stocks were mostly flat to slightly down after reporting profits in-line or above expectations. Several blowout quarters were rewarded nicely by the Street, and most importantly, there were only a handful of poor reports.

I don’t see a lot that has changed over the last few months, so my gut says that the reports won’t be as bad as stock prices are currently indicating. Of course, that doesn’t mean they will all pop to the upside if numbers are solid, but it would give me comfort in an otherwise tough market environment. In addition, there have to be at least some cases where stocks will react very well to decent reports, just because the shares were pricing in bad results.

If I am right and this earnings season turns in a fairly decent performance, hopefully the market will stabilize. Right now I have no reason to believe we are heading below the 1,200-1,225 range on the S&P 500, which is 1%-3% lower than current levels. The low end of that range represents an official 10% correction from the highs, and the high end signifies a successful retest and holding of the aforementioned June lows.

Heading into Earnings Season

This week marks the start to earnings season. Much will be made of the possibility for yet another quarter of double digit gains in profits for the second quarter. Still, I would not expect a meaningful market rally as these reports come in, even if we do end the quarter with 11 or 12 percent growth, which I think is likely. The bulls screaming that the market is cheap at 14 times forward earnings are overly optimistic, in my view.

First of all, you can only get a P/E of 13 or 14 if you use operating earnings, which is basically the number companies report after stripping out many various items that negatively impact earnings. If you use GAAP numbers, the S&P 500 is trading at 16 times this year’s estimates, and 15 times 2007 projections. That makes the market fairly valued, based on historical context, not cheap. With double digit profit growth in 2007 unlikely, you can see why I don’t think this market will soar to new highs anytime soon.

Okay, so how do investors play this market? I would focus on stocks that have below-average valuations and with whom you have a high level of confidence that they will at least hit, if not beat, their numbers. Such a strategy gives you the potential for either multiple expansion (which the S&P 500 will not provide) or earnings per share revisions to the upside (which can lead to share price gains even if multiples stay where they are). Obviously, the double play would be to get both.

Finding names that fit this description is not an easy task, but it’s really the only way to make good money in this range-bound market environment.

As Second Quarter Ends, IPO Market Heats Up

Investors had a tough second quarter as the S&P 500 closed June up a mere 1.8% for the year. Unlike prior periods, where the IPO calendar slows dramatically in dicey markets, we have actually seen a pickup in IPO activity in recent weeks. Why the sudden interest?

With the average stock not doing much of anything, investors seem to be looking anywhere for places to make money. New offerings, whether well-known consumer brands like J Crew or Mastercard, or much hyped ethanol plays like VeraSun and Aventine, offer the potential for a quick payoff, something that has been lacking for several months in the market.

The retail investor seems to be jumping in with both feet to the IPO market, which I would use as an indication that it’s time to tread carefully. Despite lackluster financials, small investors jumped all over the J Crew deal, causing a huge spike. On a valuation basis though, the stock does not appear cheap. The ethanol plays are also expensive, with the Aventine deal actually dropping more than 10% on its first day of trading last week.

History has shown that IPOs are some of the worst investments around. Just think about why this is likely the case. Companies don’t sell shares to the public unless they think they can get a great price. Why are ethanol companies going public now, even though oil prices have been high for a fairly long time? Perhaps they are sensing that speculative interest in the industry is at elevated levels and they want to take advantage of that.

The fact that many deals, including J Crew, are being brought to market by private equity firms is another red flag. These buyout firms bought companies years ago when prices were depressed. Now the so-called “smart money” is selling their stakes to the retail investor via IPOs. Which side of that trade do you think is going to come out on top?

Of course there will be exceptions, but I would caution investors to be careful when venturing into the IPO market. There is a reason why someone has decided this is the right time to sell. With initial public offerings having been relatively poor investments over time, make sure you pay attention to the stock’s valuation, not just what company you are dealing with.

M&A Not Slowing Down

Another “Merger Monday” is shaping up nicely today, as deals continue to pour in at record levels. Wachovia (WB) buying Golden West (GDW) for $25 billion is by far the biggest deal of the day, but perhaps the most interesting is the bidding war for Aztar (AZR), casino operator and owner of the Tropicana Casino in Las Vegas.

In March, Pinnacle Entertainment (PNK) agreed to acquire Aztar for $38 per share, more than 20% above where AZR stock was trading at the time. Late Friday, the two parties agreed to a revised price of $51 per share. It’s not often that a company has to increase the price of a friendly takeover bid by 34%, but in this case, three other suitors emerged and a bidding war began.

Although Pinnacle has a signed merger agreement with Aztar at $51, it might not be done yet. Two of the bidders appear to be out of the mix, as Ameristar Casinos (ASCA) officially dropped out, and Colony Capital hasn’t been heard from since their $41 bid was trumped. Columbia Entertainment, however, saw their $50 cash bid expire Friday afternoon, and could very well come over the top sometime this week.

What is all the fuss over Aztar about? The Tropicana, although fairly old in Vegas terms, sits on prime real estate on the Vegas Strip. The buyer would like to knock it down and build another brand new casino, much like the newest hot spot, Wynn Las Vegas. Vegas is hot, and as a result, Aztar’s real estate appears to be worth far more than shareholders thought a couple of months ago when the stock was trading at $30 before the initial bid from Pinnacle.

Not only will it be interesting to see how the Aztar situation is resolved, but the overall theme of an immensely robust M&A market should be a focus for investors. The best way to play this, aside from speculating on which firms get bids next, is to go with the investment banks whose advisory fees are sky-high with the current deal flow.

Companies Shunning Quarterly Guidance?

I’ve said here on several occasions that giving earnings guidance does two things, and neither one is beneficial to shareholders. One, it puts management’s focus on short term results, not a long term strategic plan for boosting shareholder value. Two, it does Wall Street analysts’ jobs for them so they can avoid having to do any real legwork on their own.

An interview on CNBC last Friday afternoon was centered around how some companies have begun to stop issuing quarterly guidance in favor of annual projections. Evidently the number of company giving guidance for three-month periods has dropped from over 60% to slightly more than 50%. I don’t expect most firms to take the Sears Holdings/Google approach of not issuing guidance at all, but this is certainly a good start. A company should never be put in a position to feel compelled to ship product on the last day of a quarter just to hit their numbers, appease shareholders, and prevent a one-day stock price blowup.

One ramification of this shift is that quarterly earnings results will be more volatile. Rather than coming in right on target or a penny ahead of consensus every quarter, there will be a lot more instances of big upside surprises and large shortfalls. This will undoubtedly make share prices more volatile during earnings season, but it will also make my job as a money manager much more fun and important as more surprises require more analysis and decision making.

Fortunately, there seem to have been relatively few earnings warnings this quarter (this is a trend I began to see last quarter as compared with prior periods), so I would guess results will be pretty good when companies begin announcing their first quarter results later this month.

First Quarter Comes to a Close

For me it’s very tough to be disappointed in any way with the market’s performance in the first quarter. I have been pleasantly surprised at how well stocks have acted throughout 2006 thus far. The S&P 500 index rose by 3.7% for the period, even as 10-year bond yields jumped substantially, from 4.40% to 4.85%.

It was an excellent backdrop for stock pickers, and the performance of my 2006 Select List echoes those sentiments. The 10 stock list has posted a gain of 12.2% since the beginning of the year. The group was led by 4 stocks that jumped more than 30% each, including Lionsgate (LGF), the movie studio behind Crash, the Oscar winner for Best Picture.

Heading into the second quarter, my outlook remains as it was on January 1st, cautiously optimistic. I still think we are set for mid-to-high single digit returns on the S&P 500 in 2006. Earnings should continue to be strong, but without multiple expansion, huge gains in the indexes are unlikely. Low double digit gains are not out of the question, but we would need many things to fall into place, including a Fed that stops raising rates soon and oil prices that are subdued. Possible, but not probable in my view.

Given that we got nearly a 4% gain in Q1, I can’t help but think we are overdue for a market correction. We haven’t seen a 10 percent drop in more than 3 years, which is very unusual. Market momentum is very strong here and first quarter earnings reports this month will likely be solid, but as we enter a seasonally weaker period for stocks, I am still expecting a pullback even if it doesn’t seem like the market wants to go down right now.

That said, there are still many individual stocks that are attractive. As share prices have rallied the list of undervalued names has undoubtedly gotten smaller, but values can still be found by those who look hard enough. And I would suggest holding some cash because when a correction comes, the list of bargains will once again expand.

Best of luck to all of you in the second quarter.

Shareholders Sue No Matter What

From the Chicago Sun-Times:

Judge OKs lawsuit by those who lost money during Kmart takeover

A federal judge in Chicago has given the green light to plaintiffs who charge that Sears Chairman Edward S. Lampert and former Sears CEO Alan Lacy failed to tell shareholders they were plotting Kmart’s takeover of Sears Roebuck and Co.

The plaintiffs making the complaint sold their Sears stock between Sept. 19 and Nov. 16, 2004, and lost out on a spike in Sears’ share price that occurred when Kmart and Sears announced Nov. 17, 2004, that Kmart would acquire Sears.

U.S. District Judge Robert W. Gettleman ruled that the aggrieved shareholders cited sufficient facts so they can try to prove that Lampert and Lacy violated securities laws by failing to fully disclose their negotiations.

The shareholders allege that Sears, with Lacy’s knowledge, was repurchasing shares at what they contend was an artificially low price, effectively increasing the interest of Lampert’s hedge fund and making Kmart’s takeover of Sears easier.

Now not only do we have shareholders who sue when stocks they own take a tumble, we also have those who sue when stocks go up after they sell? Lawsuits in this country are really getting out of hand. Let’s go through a few reasons why this story is ridiculous.

First of all, the headline doesn’t even make sense. You can’t “lose money” on a stock you no longer own. Missing out on profits and losing money are not the same thing. If you thought about buying a Powerball ticket when the jackpot hit $200 million but decided not to, you didn’t lose out on a chance to win the lottery. You simply chose not to play.

The basis of the lawsuit is that Kmart management failed to disclose they were in merger negotiations. What company in their right mind would disclose this? As soon as news of such talks hit, Sears stock would have rallied, raising the price Kmart would need to pay. This would hurt Kmart shareholders, not help them, making the deal less attractive financially. Arguing somebody broke securities law by not disclosing buyout negotiations, which could easily have broken down, is preposterous.

They go on to say that Sears was repurchasing stock at low levels to make Kmart’s takeover easier. There would be no reason for Sears to do this, it would not have a meaningful effect. Sears stock was cheap. That explains why Sears was buying back shares and why Kmart was interested in a business combination. That is just a good use of capital by both sides. Shareholders of both Sears and Kmart should be happy about that. In fact, the reason the stocks soared once news of the merger broke was because it was perceived as such a good move. Both retailers were struggling and this was seen as a way to get smaller, leaner, and more profitable.

Current Sears Holdings shareholders need not be worried. This Chicago Sun-Times article is the second I’ve read in recent days that sharply criticizes and questions the current retailing strategy of Edward Lampert and company. As long as people are still negative and focused on retail strategy and not economic value, I’m happy to be a shareholder of Sears Holdings.

WSJ Exposure and a Stock Pick

Thanks to Kevin Delaney and the rest of the team at The Wall Street Journal for featuring me yesterday in a front page story about my trading in and views on Google (GOOG). It certainly made for a fun and eventful day, most notably a full inbox and a phone ringing off the hook. If you would like to read the story, it can be accessed through in addition to March 2nd’s hard copy. I also have an electronic copy if you aren’t a WSJ online subcriber, so email me if you’d like a copy.

On to the market. I have been pleasantly surprised how well the market is acting so far this year. I am tempted to take some money off the table, but the momentum is clearly strong right now. Hopefully nothing will get in the way of that. What do readers think? Feel free to comment.

As for specific stocks, I would suggest investors take a look at Abercrombie and Fitch (ANF). The stock was down $6 yesterday after weaker-than-expected same store sales for February. A lot of hot money was in the stock, so the decline may have been more than normal. Keep in mind that SSS were still up more than 5% for the month, and February is the second least important month of the year for retailers. The stock looks very cheap down here under $60 per share.