By David Eller, Investment U Research
Wall Street likes simple stories. If you can't fit an idea into an elevator pitch, it gets glossed over or distilled down into a one-liner. Popular use of the price-to-earnings ratio (P/E) for valuation is a good example of this.
You take the price of the stock divided by the earnings of the company, and boom, you have a valuation that can be compared across companies and industries. But like any simple concept, it works until it doesn't. Right now the market looks fairly cheap, trading at a historically low P/E of 16, right? But what if the "E" isn't real? The cheap market may be an illusion.
We've seen industrial bellwethers like FedEx (NYSE: FDX) and Caterpillar (NYSE: CAT) reduce full-year guidance, but large-cap technology companies have been meeting or beating expectations.
So how are tech market leaders like Cisco (Nasdaq: CSCO) and Oracle (Nasdaq: ORCL) meeting or beatings earnings estimates in the same economic climate? The answer is simple: They're using the cash on their balance sheet to buy growth.
Cisco recently announced earnings that beat expectations by a penny and increased its dividend. Oracle also announced earnings that met expectations. But the quality of earnings declined because each used cash to buy back shares and artificially increase their earnings per share. When Cisco announced earnings in early September, people decided to look the other way. However, investors weren't as kind to Oracle, and this may be key to understanding how stocks will react as we head into 2013.
Technology companies like Cisco have plenty of cash on their balance sheets to both fund operations and also reinvest in earnings growth ? but not all industrial companies are able to do the same. As we get closer to earnings season, investors are caught between the opportunity to invest cheap (borrowed) capital in the markets and few safe havens to place it.
Looking at the market as a whole, the S&P 500 is said to be trading at a 16 P/E. This isn't overvalued and may be considered cheap ? but it could mask a nasty surprise. If earnings for 2013 need to come down by 20%, then the P/E of 16 is really a P/E of 20 (16/.8 = 20). Which is expensive for companies seeing slowing growth.
FedEx lowered guidance from $7.15 per share to $6.40 per share. Caterpillar reduced earnings guidance from $17.50 to $15 at the midpoint, representing declines of 10% and 14%, respectively. These reductions are below the 20% we talked about in the last paragraph, but they're only for a partial year, not a full 12 months.
Cisco, on the other hand, met estimates and guided to $0.46 cents for the coming quarter, which was a penny ahead of consensus. Oracle met consensus and guided in line with $0.61 for the coming quarter. Neither company gave full year guidance, and a closer look at the numbers reveals that they bought the last penny of earnings.
Oracle purchased $2.5 billion of stock, up from the $600 million it repurchased last year. If Oracle had the same share count as last quarter, it would have missed by a penny. Whether this is sneaky or good financial management, you be the judge.
At least Oracle isn't alone. Cisco spent $1.8 billion to buy $0.007 of earnings per share, but it was enough to bump EPS up to the street consensus of $0.36. The scary thing from my perspective is the level of cash that each is using. Oracle spent more on share buybacks than it made in the quarter.
The question the pros are struggling with now is what to buy with the cheap money supplied by the Fed as we head into a possible earnings slowdown in the coming weeks.
Companies like Cisco and Oracle have the balance sheets to mold earnings to match consensus, while weaker and more capital intensive companies will likely falter.
It stands to reason that the companies meeting expectations for both results and guidance will see increase in valuation, but the companies that miss are likely to trade off substantially.
This push and pull could cause substantial volatility for individual investors. But as the dust settles it could also create substantial opportunity if you stick to investing in stocks with good fundamentals and buy on dips.
Reprinted with permission of the publisher. The above story can be read on the website www.investmentU.com. The direct link is: http://www.investmentu.com/2012/October/cheap-market-illusion.html
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