STOCK WATCH


Why Earnings Matter

Jeffrey R. Kosnett

August's market storm has wreaked plenty of havoc. But look at the shares still standing.



Earnings? Oh, yeah, earnings.

June seems like eons ago, but remember that before the credit panic stuck, the chief investment topic was good second quarter earnings. Now earnings season is wrapping up and the numbers have stayed strong. But if the market stays obsessed with mortgages, hedge funds and what the Fed might do about them, will profits still count?

In a word, yes. Consider John Deere (symbol DE) which had the misfortune to report quarterly results on August 15, at the height of the craziness. Deere's earnings and the rest of its news were terrific. Sales are brisk and world agribusiness is booming. Sure, Deere shares still did a few dipsy-doodles, but when they closed at $130.72 on August 22, Deere was up 30% for the year and 12% since the August 16 bottom.

In Moline, Ill., and wherever those green tractors and combines help feed the world, earnings definitely matter.

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Or listen to Rick Campagna, senior vice president of Provident Investment Management. During the worst of the panic last week, 99% of his stocks were getting hammered, Campagna says. It didn't matter if a company was thriving or struggling. Yet through the panic, he saw encouraging signs.

"There's definitely a difference between companies that are doing well and those that are not," says Campagna, whose Pasadena, Calif., firm manages $5 billion of investments. So he's busily buying more shares of world-class industrial and construction companies like Fluor (FLR) and Manitowoc (MTW), plus some technology stocks, and even some selected financial companies.

In New York City, Rich Parower of Seligman Communications and Information fund had the same gut feeling. He watched all sorts of stocks dive for two weeks and decided a few were overpriced due to now-dashed takeover speculation. But others, such as BMC Software (BMC), McAfee (MFE) and Symantec (SYMC) were never overpriced and would gain once the craziness subsided, he figured. They've already started advancing, in fact, as have Fluor and Manitowoc. All five stocks are up more than 4% since the market's mid-day nosedive August 16.

What all these stocks have in common is strong earnings. Until mid July, investors and analysts saw the latest round of corporate earnings as the key to the stock market's summer and the second half of 2007. In the case of these five companies, all exceeded analysts' average profit estimates by at least 10%. They did this with real business growth, not financial engineering or a one-time windfalls.

With 95% of the S&P 500 companies finished reporting for the second quarter, the median earnings growth rate is 13.5%. That blows away Standard & Poor's late-June prediction that the figure would fall to around 6% and would end the long streak of quarters with double-figure growth.

Parower, like many other professionals, had been braced for much weaker numbers. "Earnings were very definitely better than we expected," he says. The 13.5% growth rate is a swell surprise because it's not much less than the 15% growth rate for all of 2006.

The best growth came in healthcare, with a second-quarter growth rate of 19%. Manufacturing and industry followed at 17%, and consumer staples at 16%.

How could estimates have been so far off? While U.S. companies earned about as much as expected at home -- meaning not as much as a year ago -- their performance in Europe was surprisingly splendid. And performance in Asia was a little better than forecast. The weaker dollar helps with profits because foreign earnings are translated into more dollars. Pessimists will say that's a temporary boost, but give American companies credit for establishing themselves in countries growing faster than our own.

Now earnings predictions for the third quarter are even worse then they were for the second quarter. Zacks earnings analysts foresee only a 3% total advance. Their strongest forecasts are for telecommunications and healthcare, at 44% and 24%, with the weakest expectations for energy and "consumer discretionary" (think Tiffany's and Nordstrom).

If a 3% gain actually comes to pass, the stock market won't be able to shake off August's losses. The Dow would do well to end 2007 at 12,500, just about where it began the year. Then again, if earnings again beat predictions, the bulls like Abby Cohen of Goldman Sachs will pound for 14,000 again.

What you can depend on amid all this angst and conjecture is earnings. Yes, when the market moves 3% in 15 minutes, good stocks will get hammered indiscriminately. But strong numbers in the second quarter shielded the market from the credit panic more than many people realize.



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