Corporate Profits Won't Impress

The average gain for the third quarter will be small. But some sectors are still humming and worth a look from investors.

By Matthew Mogul, Associate Editor, The Kiplinger Letter

October 1, 2007

Third-quarter earnings won't look so hot. Average corporate profits for companies in the Standard & Poor's 500 index will show about a 3% gain, the smallest in five years. Financial firms, which account for just over a quarter of total S&P 500 earnings, are largely to blame. The credit crunch and mortgage woes triggered sharp slowdowns in their lending, investment banking and fund management activities.

But don't despair. The overall lackluster gain says more about companies' stellar third-quarter earnings in 2006 -- against which this quarter is compared -- than it does about companies' current levels of profitability. There are also wide divergences by sector. We expect many of them to perform far better than the 3% average this quarter and to advance toward double-digit gains well into next year. Look for a respectable 8% average earnings gain for all of 2007 and a 12% increase next year.

Why will some businesses fare well when confronted with a slowing economy? The recent interest rate cut by the Federal Reserve -- and at least one more rate reduction expected by year end -- will support stocks by making it easier for companies, consumers and investors to borrow. Keep in mind that there's also a growing disconnect between corporate profits and the health of the U.S. economy. Why? A rising share of S&P 500 firms' profits comes from abroad -- about half of total profits at this point -- and foreign economies are poised to move at a faster clip than the U.S.

Here's a sector-by-sector breakdown of what to expect for the third quarter and beyond.

Winners:

• Health care will be the biggest third-quarter winner, with a 16% gain. This sector will continue to grow rapidly, with price increases outpacing inflation and baby boomers needing more attention. These firms tend to outperform those in other sectors in a declining economy: People get sick and need medicine and treatment whether the economy is up or down. Investors should check out firms such as pharmaceutical company Pfizer and medical device maker Medtronic. A few caveats: Many patents on blockbuster drugs are expiring, opening the door to greater competition from generics. Politics is another wild card. Democratic presidential hopefuls are touting health care plans that aim to cut medical costs at the expense of drug manufacturers and other providers.

• Technology will show an 11% profit advance this quarter and is positioned to perform well in the future. During a slowdown, many firms ramp up their tech expenditures in an attempt to boost productivity. Information technology is also a global sector. Firms such as Apple, Cisco Systems, IBM and Oracle do a lot of business overseas, meaning they're in a good position to weather a storm at home. On the flip side, investors should keep in mind that tech shares have a history of being relatively volatile when the stock market is wobbly.

• Consumer staples such as food, beverages, shampoo and toothpaste should be close behind, with a 7% earnings increase. This sector is largely immune to economic ups and downs. Companies from Altria Group to PepsiCo to Procter & Gamble are all likely to bear up in coming quarters.

• Industrials will also turn in an average 7% gain. Big manufacturers with extensive overseas operations will outperform smaller players. Think Boeing, Caterpillar and Deere & Co.

• Consumer discretionary is a red flag, particularly companies that make or sell autos, homes or home improvement products. The housing slump now looks as if it will continue well into 2008, if not longer, keeping this sector beaten down for some time to come. Expect an 11% earnings decline for the third quarter in consumer discretionary, and continued poor performance through next year. Firms to avoid: Toll Brothers, Beazer Homes, Home Depot, Lowe's, General Motors and Ford. Concessions on health costs by the United Auto Workers union will probably improve auto manufacturers' profit potential, but it will take a while for the benefits to kick in.

• Financials will post a 4% decline in earnings. In principle, this sector should show a small bounceback in the fourth quarter, but there's a huge risk factor: the likelihood that many lenders will be forced to write down bad debt tied to subprime-related securities losses. Investors wanting to buy in should look at large, diversified firms such as AIG, Bank of America and Citigroup.

• Energy will show a 4% earnings drop for the third quarter. But don't be fooled. The quarterly drop is due mainly to the comparison with a record third quarter a year ago. Energy prices will remain fairly high in 2008 and will power record earnings for firms such as ExxonMobil. Also look for positive results from companies that make oil rigs and provide oil field services, including Halliburton Co. and Schlumberger Ltd.

What does all this mean for investors? There are plenty of opportunities. As always, every sector has both good and bad companies. In general, larger firms with big overseas operations deserve a close look. So do mutual funds that focus on such stocks, such as Vanguard Primecap Core and Marsico Growth. These Fortune 500 firms have solid balance sheets with big cash reserves, they pay healthy dividends, and they are buying back shares -- all of which will support the share price.

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