US fundamentals remain very strong, and even though this is one of the longest bull markets in history, the economic recovery is also one of the shallowest in history, suggesting that the bull market may go on for some time to come. John Stephenson picks his three favourite stocks to buy now.
US corporate earnings are poised to extend a run of double-digit growth in the second quarter, providing a balm for a stock market that has languished as investors have grappled with threats ranging from fractious trade relations to tightening monetary policy.
Analysts expect earnings from S&P 500 companies to grow 20 per cent plus in the second quarter from the year-earlier period, according to FactSet. Historically, earnings per share (EPS) estimates are on the low side by approximately three to four per cent, suggesting that EPS increases could be as high as 23 or 24 per cent this quarter. Despite fears that earnings peaked in the first quarter, they are still on pace for the second-fastest rate of growth in nearly eight years. Revenue is also expected to impress, with projected growth of 8.7 per cent over the year prior—the fastest rate since the third quarter of 2011.
The buoyant outlook for earnings highlights the vigour of US corporations, now nine years into a domestic economic expansion. Gains from corporate tax cuts, a robust US economy and confidence among small business owners and consumers have given corporate earnings a fresh boost this year, helping offset headwinds like fractious trade policies and rising interest rates.
The results show the growth streak that has supported the long stock rally that isn’t over yet, something that should reassure investors headed into the busiest period of reporting season, which gets going shortly.
Earnings estimates move up
Rallying oil prices, strong US economic data and buoyant consumer confidence have pushed analysts’ earnings estimates higher since the start of the second quarter. This is a departure from previous quarters, when analysts typically lowered their expectations as they got closer to the start of earnings season.
Much of the boost has come from the S&P 500’s energy sector, which has rallied as dwindling oil production in Venezuela and fears of a supply disruption in Iran have sent US crude oil prices soaring above $70 a barrel again.
Energy companies in the S&P 500 are expected to post year-over-year earnings growth of 144% in the second quarter, up from 115% on March 31, according to FactSet. The upbeat outlook for profits has helped lift oil stocks.
The S&P 500’s technology stocks sector—the best performing group in the broad index this year—is also expected to impress. Strong sales momentum has analysts forecasting double-digit earnings growth for firms in the semiconductor, internet software & services, technology hardware, storage & peripherals and IT services industries.
Those broadly positive sector forecasts have helped offset cuts in earnings estimates for consumer staples stocks. Shares in that sector have slid in recent months as investors have worried that tariffs from Canada, Mexico and the European Union on goods ranging from orange juice to pork chops could dent profitability.
Analysts have lowered earnings estimates for about three-quarter of firms in the consumer sector since March 31, including Campbell Soup Co., Kraft Heinz Co. and Coca-Cola Co. Shares of consumer staples companies in the S&P 500 are down 9.1 per cent for the year, placing them among the worst-performing sectors in the broad index.
What I Recommend
Historically, analysts’ estimates tend to fall by, on average, two per cent going into earnings season. This time around by contrast, earnings estimates for the second quarter have risen modestly.
Heading into this earning season the cyclical names are expected to deliver the best results. Even after factoring out the tax benefits, the technology, financials, energy, materials and internet retail sectors of the market are expected to deliver double-digit earnings per share growth. Telecom, staples, and discretionary (ex-internet retail) sectors of the market are all forecast to deliver negative earnings per share growth this quarter.
The greatest value may well lie in financial services stocks this time around. While there are some very good reasons for shunning the sector, namely that the banks are highly-levered, heavily-regulated, cyclical-commodity companies with a history of suffering some unpleasant blowups every decade or so. But this time around things may be looking up for the sector, given the recent sell-off in the space. Banks historically trade at a price to earnings ratio of 73 per cent to 78 per cent of the stock market’s price earnings ratio, and today they are sitting at 64 per cent of the market.
The balance sheets of banks are the least risky than at any time in the past 30 years, while the returns are up. This suggests that the banks should revert to their historical discount to the market offering investors a healthy return from here.
Three stocks to buy
One stock I really like is PNC Financial Services Group (NYSE—PNC). PNC has $379 billion in assets and is one of the largest diversified financial services companies in the United States, headquartered in Pittsburgh, Pennsylvania. PNC has businesses engaged in retail banking and asset management, providing many of its products and services nationally, as well as other products and services in PNC’s primary geographic markets and internationally. The company is very well positioned for rising interest rates and is expanding its middle markets and corporate finance businesses into Dallas, Kansas City and Minneapolis. The bank has a continued focus on reducing operating expenses and non-interest income accounts for approximately 42 per cent of PNC’s total revenues, in line with top performing peers at 40-50 per cent or higher. I have a Buy rating and a twelve-month price target of $175 per share for PNC Financial Services Group.
Another name that I really like is manufacturing stock Micron Technology Inc. (NASDAQ—MU). The company is based in Boise, Idaho and is a manufacturer of semiconductor devices, primarily DRAM and NAND memory. The company has four business units. The Compute and Networking Business Unit includes memory products sold into computer, networking graphics, and cloud server markets. The Storage Business Unit includes memory and storage products sold into enterprise, client, cloud, and removable storage markets. The Mobile Business Unit manufactures memory products sold into smart-phone, tablet and other mobile-device markets. Lastly, the Embedded Business Unit produces memory products that are sold into the automotive, industrial, connected home and consumer electronics markets. The stock trades at just 11.72 times 2018 estimated earnings making it very attractive from a valuation standpoint.
While the semiconductor industry has a history of volatility, I believe the cycle(s) going forward will be more muted and less volatile. This means that memory companies should earn more profits and free cash flow over the cycle than historical trends would suggest. In part, this is because of the increasing capital intensity required for the business that limits the boom/bust nature of the business. Additionally, the DRAM industry has seen a severe consolidation, falling from 15 players in 1995 to just three today. As well, the market for DRAM has become more diversified. In 2007, the DRAM industry was driven by PCs, which accounted for 42 per cent of industry revenues. Today, PCs account for just 16 per cent of revenues while servers and other markets which are more secular in their content uptick, now account for 48 per cent of total revenues. The widespread adoption of smartphones now accounts for 37 per cent of sales today versus just 3 per cent a decade ago. I have a Buy rating and a twelve-month price target of $85 per share for Micron Technology, Inc.
Another company that I like is Amazon.com Inc. (NASDAQ—AMZN). Amazon is the largest global retailer on the Internet and operates in seven countries with over 300 million customers worldwide. Amazon should be able to realize continued market share gains. Already Amazon accounts for approximately 20 per cent of US Online Retail Sales, but the company’s strong mobile positioning and infrastructure advantages facilitating next-day and same-day delivery should allow Amazon to continue to take share. Margins should expand back to the 2003-2010 average 6 per cent level and to long-term levels in the high-single digit percentage range. I view scale, improved vendor terms, the ongoing mix shift to third-party sales, likely driven by Fulfillment by Amazon and Prime and Amazon Web Services as likely catalysts for gross margin expansion. Additionally, Amazon has one of the best management teams on the Internet given their consistency, operational and strategic track record, focus on innovation and customer service, and long-term shareholder orientation. I have a Buy rating and a 12-month price target of $1950 per share on consumer goods stock Amazon.com Inc.
The US fundamentals remain very strong, and even though this is one of the longest bull markets in history, the economic recovery is also one of the shallowest in history, suggesting that the bull market may go on for some time to come. While trade concerns rank high in the collective mindset these days, the US economy is without a doubt the strongest globally and earnings are likely to be very strong this quarter, which will help keep the fire lit under the stock market for the foreseeable future.
John Stephenson is an award-winning portfolio manager and the President and CEO of Stephenson & Company Capital Management Inc. in Toronto. He is the author of “The Little Book of Commodity Investing” and “Shell Shocked: How Canadians Can Invest After the Collapse.” He is also the publisher of Strategic Investor (www.StephensonFiles.com). He can be reached at (647) 775-8360 or (844) 208-8817, or firstname.lastname@example.org.
This is an edited version of an article that was originally published for subscribers in the July 2018/Second Report of The MoneyLetter. You can profit from the award-winning advice subscribers receive regularly in The MoneyLetter.
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