Thursday, June 18, 2015

Bernanke Signals Flexibility on Tapering

Federal Reserve Board Chairman Ben Bernanke told lawmakers Wednesday that if the economy fails to satisfy the Fed’s expectations, its plans to taper bond buying could change and the Fed could even “potentially increase purchases for a time.”

The economy continues to recover at a “moderate pace,” with housing having contributed “significantly” to recent gains, but the unemployment rate is only seeing “moderate” improvement — standing at 7.6% in June, Bernanke said in the Fed's semiannual monetary report to members of the House Financial Services Committee.

Bernanke signaled to the committee that the Fed would adjust its bond-buying program — better known as quantitative easing — depending on how the economy performs. “Our intention is to keep monetary policy accommodative,” he said.

“We are relying on near-zero short-term interest rates, together with our forward guidance that rates will continue to be exceptionally low — our second tool — to help maintain a high degree of monetary accommodation for an extended period after asset purchases end, even as the economic recovery strengthens and unemployment declines toward more-normal levels,” Bernanke told lawmakers.

After Bernanke delivered his report, 10-year Treasury yields fell to 2.49% from 2.63%. The Dow Jones industrial average rose 0.1% in afternoon trading, while the Standard & Poor's 500 index and Nasdaq rose 0.3% and 0.2% respectively.

In late June, Bernanke said that the Fed would likely curtail its stimulus bond buying later this year, which sent the markets into a tailspin and spooked investors.

As Bernanke stated in his prepared testimony, “if economic conditions were to improve faster than expected, and inflation appeared to be rising decisively back toward our objective, the pace of asset purchases could be reduced somewhat more quickly.” However, “on the other hand, if the outlook for employment were to become relatively less favorable, if inflation did not appear to be moving back toward 2%, or if financial conditions — which have tightened recently — were judged to be insufficiently accommodative to allow us to attain our mandated objectives, the current pace of purchases could be maintained for longer.”

Jim O’Sullivan, chief U.S. economist at High Frequency Economics, noted in reaction to Bernanke’s testimony, that in starting to scale down the purchasing program, “the data will matter,” as Bernanke said the Fed is not “on a preset course.” O’Sullivan said that Bernanke was “emphasizing the no-imminent-tightening point a bit more” than he has before.

The lengthy hearing covered many issues, including worries about the recent spike in mortgage interest rates. “Mortgage rates are a bit higher and we have to monitor that,” Bernanke said. “We’ll see how housing and house prices go from here.”

In his testimony, Bernanke said that housing has “contributed significantly to recent gains in economic activity.” Home sales, house prices, and residential construction, he said, “have moved up over the past year, supported by low mortgage rates and improved confidence in both the housing market and the economy.” He went on to note that “rising housing construction and home sales are adding to job growth, and substantial increases in home prices are bolstering household finances and consumer spending while reducing the number of homeowners with underwater mortgages.” Housing activity and prices, he said, “seem likely to continue to recover, notwithstanding the recent increases in mortgage rates,” noting the importance of monitoring developments in this sector carefully.

Some lawmakers noted that both the House and Senate are currently considering legislation to reform the government-sponsored enterprises — Fannie Mae and Freddie Mac. Bernanke said that the Fed “agrees” that some type of reform needs to take place, as the Fed “for many years warned about [GSEs’] lack of capital.”

The key question, Bernanke said, is “What role should the government play?” The private sector should play a bigger role in housing finance going forward, one reason being so there’s “more product innovation,” he said.

As to unemployment, Bernanke said while the 7.6% rate in June is a half percentage point lower than in the months before the Federal Open Market Committee (FOMC) initiated its current asset purchase program in September, the “jobs situation is far from satisfactory.”

Despite the fact that nonfarm payroll employment has increased by an average of about 200,000 jobs per month so far this year, “the unemployment rate remains well above its longer-run normal level, and rates of underemployment and long-term unemployment are still much too high,” Bernanke said.

As to inflation, Bernanke said that consumer price inflation “has been running below” the FOMC’s “longer-run objective of 2%.” With “measures of longer-term inflation expectations hav[ing] generally remained stable,” this “should help move inflation back up toward 2%,” he said. “However, the committee is certainly aware that very low inflation poses risks to economic performance — for example, by raising the real cost of capital investment — and increases the risk of outright deflation. Consequently, we will monitor this situation closely as well, and we will act as needed to ensure that inflation moves back toward our 2% objective over time.”

---

Check out Upbeat Jobs Report Signals Quicker QE Tapering on ThinkAdvisor.

Wednesday, June 17, 2015

Is Taper No Longer an Issue for Stocks? - Ahead of Wall ...

Wednesday, July 10, 2013

Stocks are within striking distance of reclaiming the all-time high reached less than two months back, with the pullback resulting concerns that the Fed was getting ready to pare back its QE program. We will get more clarity on the Fed question this afternoon with the release of the minutes of the Fed's June meeting. Also at play in today's session are renewed concerns about China's growth outlook after another weak economic reading – this time about that country's exports.

The stock market's ability to claw back its losses over the last few weeks despite the persistent rise in benchmark treasury yields, is very impressive. My sense is that these gains will prove sustainable only if they reflect investors' collective judgment that an improved economic outlook trumps less Fed QE and somewhat higher interest rates. But if the market's gains reflect the hope that 'Tapering' was not imminent, then we may be at risk of giving all of these back in the coming days.

I continue to believe that U.S. economic outlook was stable enough to allow the Fed to start pulling back from its QE program later this year. A number of Fed officials went out of their way to dial back Bernanke's fairly explicit pronouncements on the 'Taper' question. But the bond market got it right from the get go, pushing 10-year treasury yields by almost 100 basis points since early May. This afternoon's minutes of the June FOMC meeting will likely confirm that Bernanke's comments were more in-line with the emerging majority on the committee.

With respect to China's growth outlook, Alcoa (AA) appeared to be reassuringly explicit in its earnings release on Monday, belying concerns raised by a host of weak economic readings in recent days. But today's official export numbers run counter to Alcoa's claims and raise further doubts about that country's picture. The decline in Chinese exports in June, the first in a non-holiday month since late 2009, is likel! y not a one-off event and likely reflective of some loss of competitiveness for China's export sector. Competitiveness has suffered to some extent relative to lower wage regional countries like Vietnam as a result of rising wages and unfavorable exchange rate movements. The continued economic problems in Europe also remain a headwind, as the more than 8% drop in exports to Europe reconfirm.

The China growth question magnifies similar concerns about the rest of the emerging world as the recent growth downgrade by the IMF shows. The China issue will figure prominently in the Yum Brand's (YUM) earnings release later today as well, though YUM is dealing with a number of company-specific issues that are not directly tied to China's growth outlook.

But the fact remains that a big part of the expected earnings growth in the second half of the 2013 and full year 2014 for the S&P 500 as a whole is contingent on improved economic growth beyond the U.S. borders. For context, keep in mind that consensus earnings expectations are looking for earnings growth to accelerate from the first-half 2013's less than +3% pace to more than +9% rate in the second half and accelerate even further to more than +11% in 2014. With more than 40% of S&P 500 earnings coming from international markets, those growth expectations will likely need to be scaled back.

Sheraz Mian
Director of Research

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Tuesday, June 16, 2015

3-Year Review: Best & Worst ETFs In Each Sector

In the last few years, investors have slowly found their way back to equity markets as more lucrative opportunities continue to present themselves. And with more and more investors adopting higher risk tolerances, bullish momentum has undoubtedly become a dominant force on Wall Street, pushing equity markets into uncharted territory. And though across the board, most corners of the equity market have flourished in recent years, there have been certain sectors that have continuously outperformed while others have missed the mark .

Below, we highlight a handful of ETFs across each sector that have performed well over the past three years, as well as those that have struggled to keep up with the equity market's quick pace (note that inverse and leveraged ETFs are excluded from this list – data as of 7/29/13):

Consumer Discretionary: Retail, Leisure & Entertainment Soar; International Funds StruggleIn the consumer discretionary space, two retail ETFs (XRT and PMR) and a leisure and entertainment fund came out on top, posting returns above 100% over the trailing three-year period. International consumer discretionary ETFs, however, posted lower returns, while the China Consumer ETF slipped nearly 16%.

Consumer Staples: Small Caps & Alternative Weighting Methodologies Deliver; Foreign Exposure Ekes Out Small GainsAlternative weighting methodologies have proved their worth in the consumer staples sector, with the AlphaDEX , SmallCap , and equal weight  funds delivering returns of over 70%. The Brazil and international-targeted ETFs (IPS and AXSL), however, posted significantly lower returns.

Energy: Alternative Weighting Wins Again; Solar and Coal StruggleAs with the consumer staples sector, energy ETFs that utilized alternative weighting methodologies also came out on top. PXE, PSCE, and PXI all posted returns around 80%. The two solar funds (KWT and TAN) as well as the coal ETF have struggled over the trailing three-year period, posting double-digit losses .
Financials: Small Cap, AlphaDex, and Regional Banks Come Out on Top; Emerging Market Funds SlumpAnother small cap, , and the AlphaDEX fund delivered stellar returns in the financials sector, while a regional banking ETF also performed well. Investors who parked their assets in financial equities from emerging markets, however, suffered losses over the past three years.

Healthcare: Biotechs and Pharma Skyrocket, Medical Devices and International Options Fall BehindIn the healthcare space, biotechnology-targeted funds have delivered stellar returns over the trailing three-year period; Van Eck's Market Vectors Biotech ETF has gained an incredible 161%. The medical devices and international healthcare ETFs, however, have struggled to gain traction.

Industrials: Dynamic, Small Cap, and Aerospace Soar; Shipping and Chinese Funds StruggleBesides the small cap and alternative weighting methodologies (which have proven to be great picks over the years), aerospace and defense equities have also posted compelling returns. The shipping  and China-focused ETFs, however, were the worst performers in the industrials sector.

Materials: Homebuilders and Construction Funds Catch Fire; Metal Miners Miss The MarkWith housing data showing significant uptrends in recent years, it perhaps is not surprising to see homebuilders and construction ETFs post stellar returns. Metal miners, however, have taken significant hits over the trailing three-year period .

Real Estate: Retail And Residential Funds Soar; Mortgage and Global Options Post Modest GainsEvery real estate fund delivered strong returns over the last three years, as the housing market continues to show encouraging signs. Coming out on top were the Retail , REIT and Residential  funds. Chinese and global real estate, however, did not post as lucrative returns as their domestic counterparts

Technology: Internet Funds Come Out on Top; Nanotech SlipsIn the tech space, two internet funds (PNQI and FDN) as well as a smal! l cap ETF! were the top performers, logging in double digit returns. The nanotechnology-focused fund , however, lost over 17% over the last three years.

Telecom: Domestic Picks Post Stellar ReturnsAcross the board, telecom ETFs have delivered strong gains over the last three years, with Vanguard's Telecom ETF rising more than 60%.

Utilities: Small Cap and Equal Weight Deliver; Emerging Market Funds Slip Into Negative TerritoryOnce again, small cap and equal-weight ETFs came out on top in the utilities sector, while funds with exposure to emerging market economies suffered losses.

Follow me on Twitter @DPylypczak.

Disclosure: No positions at time of writing.

Monday, June 15, 2015

DSW to Kick Stock with 2-for-1 Split

Management at footwear retailer DSW (NYSE: DSW  ) raised guidance 5.5% for the full year to $3.60 to $3.80 per share, and said it would split its Class A stock 2-for-1.

If approved by shareholders, DSW will issue one share of Class A stock for each Class A or Class B share outstanding. The split is expected to create a total of approximately 90.2 million shares, comprised of approximately 81.6 million Class A shares, which will continue to hold one vote per share, and 8.6 million Class B shares, which will hold eight votes per share, with the voting control of the Class B shareholders reduced from 65% to approximately 46% post-split.

The split was brought about as a result of second-quarter revenues jumping 9% from the year-ago period to $558 million as same-store sales rose 4.3% year over year with the anticipation they would continue to grow in the low-single-digit range.

In conjunction with the stock split, the board will also seek an amendment to allow DSW to increase the number of authorized Class A shares from 170 million to 250 million.

Headquartered inColumbus, Ohio, DSW operates 377 Designer Shoe Warehouse stores in 42 states, the District of Columbia, and Puerto Rico while also supplying footwear to 351 leased affiliated business group locations. The stock rose less than 1% today, closing at $77.56 per share.

Tuesday, June 9, 2015

Marvel Is Never Getting Spider-Man Back -- Here's Why

How crazy are fans for comic-book movies? Hours after activist investor Daniel Loeb released a letter arguing that Sony (NYSE: SNE  ) should make better use of its entertainment assets, the Internet was ablaze with rumors that the company might sell the rights to make Spider-Man movies back to Marvel and parent Walt Disney (NYSE: DIS  ) . Sony has since said it plans to consider Loeb's proposal yet makes no mention of disposing any of its assets.

It's hard to blame fans for getting the story wrong. Spidey is Marvel's most visible character, and Loeb is Sony's largest shareholder through his fund, Third Point LLC. He wants the company raising capital for bolstering Sony's important-but-beleaguered electronics division. An asset sale would be a natural option, says Tim Beyers of Motley Fool Rule Breakers and Motley Fool Supernova in the following video.

Unfortunately, Loeb's idea is more complicated. He wants to take 15% to 20% of Sony Entertainment public and make the resulting stock available primarily to management as a carrot to boost performance of movie assets such as The Amazing Spider-Man 2, which is filming now.

Surprised? Don't be. Last year, Disney agreed to forfeit Marvel's claim to Spider-Man film rights in exchange for 100% of the merchandising haul. Disney might gain some influence were it to buy into a Sony Entertainment IPO, but that's presuming Sony executives take Loeb's proposal serious enough to go through with an offering. And that's anything but a guarantee, Tim says.

Do you agree? Please watch to get Tim's full take, and then leave a comment to let us know how you would unlock Spidey's big-screen value.

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Monday, June 8, 2015

Best Buy: It's Getting Better, But for How Long?

On Tuesday, Best Buy (NYSE: BBY  ) will release its latest quarterly results. The key to making smart investment decisions on stocks reporting earnings is to anticipate how they'll do before they announce results, leaving you fully prepared to respond quickly to whatever inevitable surprises arise. That way, you'll be less likely to make an uninformed knee-jerk reaction to news that turns out to be exactly the wrong move.

Best Buy has struggled for years under the weight of competitive pressures from online retailers, as the electronics retailer has been one of the primary victims of the showrooming trend whereby shoppers go to a store to see items that they then buy elsewhere online for less. Yet more recently, the company has shown signs of turning its fortunes around. Let's take an early look at what's been happening with Best Buy over the past quarter and what we're likely to see in its quarterly report.

Stats on Best Buy

Analyst EPS Estimate

$0.25

Change From Year-Ago EPS

(65%)

Revenue Estimate

$10.64 billion

Change From Year-Ago Revenue

(8.3%)

Earnings Beats in Past 4 Quarters

2

Source: Yahoo! Finance.

Will Best Buy keep moving forward this quarter?
Analysts have had mixed views on Best Buy's earnings prospects recently, as they've cut their estimates for the just-ended quarter by $0.20 per share but modestly raised their full-year fiscal 2014 and 2015 estimates. The stock has squarely focused on long-term potential for the company, as shares have soared 80% since mid-February.

Best Buy's actions over the past quarter have contributed toward CEO Hubert Joly's "Renew Blue" turnaround strategy, under which the company is looking to improve its customer service, boost its presence in e-commerce, and cut its overhead. For instance, Best Buy's decision to match prices of Amazon.com (NASDAQ: AMZN  ) and other online retailers as well as retail-store competitors is geared not only toward getting people to buy more in-store purchases but also at driving customers toward seeing Best Buy's website as a low-price alternative.

One big initiative announced in early April involves smartphone giant Samsung using the store-within-store format at 1,400 Best Buy locations. For Samsung, the move is clearly an attempt to put together some form of competition against Apple (NASDAQ: AAPL  ) and its huge retail presence through its highly successful Apple Stores, yet without the massive capital expenditure that would be necessary to establish its own independent store network. For Best Buy, though, the potential could be much higher, as it could bring in more traffic not just for smartphone purchases but for its other merchandise.

Best Buy has also made some strategic moves during the quarter to refocus on its core business. Less than a month ago, it sold its 50% stake in the Best Buy Europe joint venture to partner Carphone Warehouse, raising about $775 million in cash and eliminating the distraction of having to deal with the chain in a tough economic environment in Europe right now.

Another long-awaited boost could come if the proposed federal Internet sales-tax bill becomes law. Amazon, eBay (NASDAQ: EBAY  ) , and other online retailers without physical presences in many states have had a big advantage over Best Buy, and given the high-ticket items that Best Buy sells, closing the sales-tax gap will make the substantial savings from showrooming disappear if the measure passes.

In Best Buy's report, watch for comments from management on how its recent initiatives are bearing fruit with real financial improvements. As good as the plan's proposals sound, it's important for the company to point to tangible results to prove that Best Buy is actually moving in the right direction.

The battle between bricks-and-mortar stores and e-commerce battle will rage on for a while, and to get more information about the unanswered questions about Best Buy's future, turn to the Fool's premium research report on the stock. Inside, you'll get in-depth analysis of how new leadership will perform, whether a smaller store format work out for the company, and much more. Simply click here now to claim your comprehensive report today.

Click here to add Best Buy to My Watchlist, which can find all of our Foolish analysis on it and all your other stocks.

Thursday, June 4, 2015

Few Steps Remain in American Airlines, US Airways Merger

american airlines us airways merger bankruptcy regulatory approvalMatt Rourke/AP DALLAS -- US Airways began studying a potential merger with American Airlines several months before American filed for bankruptcy protection in late 2011, according to papers filed Monday by the two companies. The documents give a blow-by-blow account of how the merger was negotiated, including the thorny issues of how to share ownership of the merged company and who would run it. The companies also revived a proposed $20 million severance deal for Tom Horton, the CEO of American parent AMR Corp. A federal judge had declined to approve the payout, finding that it violated a 2005 bankruptcy law, but he had left open the possibility that a payment could be reconsidered later. US Airways Group Inc. (LCC), whose CEO, Doug Parker, will run the combined company, played up the importance of Monday's filings with the bankruptcy court in New York and the U.S. Securities and Exchange Commission. "With these materials filed, we are one step closer to completing the merger, which we expect to occur in the third quarter of this year," US Airways officials said a memo to employees. The bankruptcy court has already signaled approval for the merger, which would create the world's largest airline. The deal faces only a few more hurdles, including approval from the U.S. Justice Department and US Airways shareholders. AMR will have 60 days to win support among creditors for its reorganization plan. Major creditors were closely involved in negotiations leading to the merger announcement in February, so it seems unlikely that they would derail the plan that will be considered by U.S. Bankruptcy Judge Sean Lane. It's less clear whether antitrust regulators in the Justice Department will impose major conditions on the deal. Regulators approved other big airline mergers -- Delta and Northwest, United and Continental, Southwest (LUV) and AirTran -- so industry analysts expect them to let this deal pass. The Justice Department, however, could require the American-US Airways combination to give up takeoff and landing slots at Washington's busy Reagan National Airport, where it would be the dominant carrier, and possibly slots in New York, too. The company will be called American Airlines Group Inc. It is expected to operate more than 6,700 flights a day to 336 destinations in 56 countries and have about 100,000 employees. Based on current figures, American will emerge slightly bigger than United Airlines (UAL) and Delta Air Lines (DAL) in the number of miles flown by passengers, the usual standard for ranking carriers. Parker will be chairman and CEO after Horton steps down as chairman in 2014. Parker would get $19.5 million if he is terminated by the new company for a reason other than misconduct, according to a separate filing Monday. The merger is a coup for Parker, who just a decade ago was running a much smaller carrier called America West Airlines. He merged that airline with US Airways, and then relentlessly pursued a deal with AMR. According to Monday's filings, US Airways executives briefed their board about a potential merger in April 2011 -- seven months before American and AMR filed for bankruptcy protection. As has been previously reported, Parker and Horton even spoke about a deal during an industry event that year, but Horton initially dismissed the idea, saying American preferred to focus first on fixing its own business. Parker persuaded American's unions and many AMR creditors that a merger would fare better than an independent American, however, and forced AMR into negotiations. Leaders of the two companies then haggled over ownership split and management titles. AMR creditors and unions will own 72 percent of the new company, and US Airways shareholders will get the other 28 percent. ---

10. Microsoft Income tax expense: $4.57 billion Earnings before taxes: $20.03 billion Revenue: $72.93 billion 1-yr. share price change: -12.04%

Wednesday, June 3, 2015

ACADIA Pharmaceuticals Skyrockets on Accelerated NDA Filing

Although we don't believe in timing the market or panicking over market movements, we do like to keep an eye on big changes -- just in case they're material to our investing thesis.

What: Shares of ACADIA Pharmaceuticals (NASDAQ: ACAD  ) , a clinical-stage biopharmaceutical company, skyrocketed as much as 54% after it announced that it was filing an accelerated new drug application for Pimavanserin after discussions with the Food and Drug Administration.

So what: Pimavanserin, an experimental anti-psychosis drug for people with Parkinson's disease, breezed through its late-stage clinical trial, meeting the primary endpoint of "highly significant antipsychotic activity," and also meeting the secondary endpoint of improved motoric tolerability. ACADIA had been planning to run a confirmatory phase 3 trial, which it planned to begin enrolling patients in this quarter. However, the data thus far, and the discussion between the FDA and ACADIA, warranted an early drug submission.

Now what: I'd say this is definitely a step in the right direction toward getting Pimavanserin approved. But, let's also keep in mind that what the FDA does initially and what its panel or final ruling may indicate can occasionally be two different things. Another factor to consider is that most Wall Street peak sales estimates for Pimavanserin are around $300 million within the U.S. Acadia's valuation is pushing $950 million following today's pop, meaning it's valued at more than three times peak sales. To me, that seems a bit lofty for its first potential FDA-approved drug.

Craving more input? Start by adding ACADIA Pharmaceuticals to your free and personalized watchlist so you can keep up on the latest news with the company.

While you can certainly make huge gains in biotechs like ACADIA, the best investing approach is to choose great companies and stick with them for the long term. The Motley Fool's free report "3 Stocks That Will Help You Retire Rich" names stocks that could help you build long-term wealth and retire well, along with some winning wealth-building strategies that every investor should be aware of. Click here now to keep reading.

Monday, June 1, 2015

Valuing Stocks Using a Snapshot Multiple Requires Earnings Predictability

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In How to Value a Stock Using the Income Statement, I discussed the conflict between (1) the theoretically-pure way to measure the value of a business as an ongoing concern – i.e., discounting the company's annual free cash flows in perpetuity at an interest rate that accounts for business risk – and (2) the practical difficulties of accurately estimating either future business risk or the company's annual cash flows over the next 10 years let alone in perpetuity.

Given the practical difficulties of accurately estimating a multitude of future data points, a short-cut method that many smart investors use to value a stock is to limit the estimation process to a single number — a snapshot multiple of a company's current earnings (or EBITDA or free cash flow or book value).

On the surface, estimating a single number is easier than estimating multiple numbers, but the reality is that this distinction is somewhat illusory because several data "inputs" must be estimated in order to generate the single "output" multiple. Most important inputs are future earnings growth and cost of capital (i.e., business risk). Earnings growth may reasonably be estimated from past experience if the company's business is stable, but business risk is a slippery measure that can easily be overshot or undershot.

Only Use P/E Ratios to Value Companies with "Predictable" Earnings

Because of the inherent uncertainties in estimation, I previously wrote that:

I would only consider using a P/E ratio on stable stocks with a prolonged operating history and a modicum of earnings-growth reliability.

Earnings predictability simply means that a company's earnings have historically grown in a consistently stable pattern that is likely to continue in the future.  In contrast, a 2008 study found that corporate earnings that are very volatile over the past five years – jumping up and down haphazardly f! rom one quarter to the next – typically signal uncertainty and unpredictable earnings for five years into the future:

Earnings volatility captures the effects of real and unavoidable economic volatility. Intuitively, firms operating in environments subject to large economic shocks are likely to have both more volatile earnings and less predictable earnings.

The volatility of reported earnings also reflects important aspects of the accounting determination of income. One such aspect is the quality of matching of expenses to revenues. Poor matching acts as noise in the economic relation between revenues and expenses, and thus the volatility of reported earnings increases in poor matching. Poor matching is also associated with poor earnings predictability because the matching noise in reported earnings obscures the underlying economic relation that governs the evolution of earnings over successive periods.

Earnings volatility not only reduces earnings predictability, but it also signals a company without a competitive advantage that has no control over pricing or a loyal customer base, but is vulnerable to the whims of a commoditized marketplace. A 2011 study found that the stocks of companies with high earnings uncertainty significantly underperform the stocks of companies with predictable earnings and that high earnings volatility "strongly predicts lower future earnings." This helps explain "the greatest anomaly in finance", where stocks with low betas (a measure of price volatility relative to a benchmark index) have historically outperformed high-beta stocks. Roadrunner's six-point safety-rating system awards a safety point to low-beta stocks because of this outperformance potential.

A 10-year study by Gurufocus.com similarly found that companies with predictable earnings outperformed. In fact, based on their five-point rating system of predictability, relative outperformance increased in perfect lockstep with increases in predictability:

Companies with Predictab! le Earnin! gs Outperform the Market
Predictability Rank5-Star4.5-Star4 -Star3.5-Star3 -Star2.5-Star2 -Star1-Star (non-predictable)Average among all

Average Annualized Gain (Jan. 1998- Aug. 2008)

12.1%

10.6%

9.8%

9.3%

8.2%

7.3%

6.0%

1.1%

3.1%

% that are in loss with 10-year holding period

3%

10%

8%

9%

11%

18%

16%

45%

37%

Source: gurufocus.com

Below is a list of ten small-cap stocks that currently enjoy the maximum five-star rating for earnings predictability:

Ten Very Predictable Small Caps
Company10-Year Annualized EBITDA Growth RateMarket CapitalizationIndustry

Medifast (NYSE: MED)

29.2%

$411 million

Weight Loss Products

World Acceptance (Nasdaq: WRLD)

20.1%

$761 million

Small-loan Consumer Finance

Neogen (Nasdaq: NEOG)

19.6%

$1.4 billion

Food Safety and Veterinary Products

NIC (Nasdaq: EGOV)

19.4%

$1.0 billion

Government Application Software

Thoratec (Nasdaq: THOR)

18.8%

$1.9 billion

Heart Medical Devices

Exponent (Nasdaq: EXPO)

16.0%

$958 million

Engineering and Scientific Consulting

The Andersons (Nasdaq: ANDE)

11.9%

$1.5 billion

Farm Products

Munro Muffler Brake (Nasdaq: MNRO)

11.6%

$1.7 billion

Auto Parts

General Communication (Nasdaq: GNCMA)

11.0%

$470 million

Alaska Telecommunications

Papa John's International (Nasdaq: PZZA)

10.8%

$1.8 billion

Pizza

Source: Gurufocus.com

Value Line Investment Survey also ranks stocks by earnings predictability. There must be something to this!

Warren Buffett Likes Stocks with Bond-Like Cash-Flows

Warren Buffett, one of the greatest investors of all time, doesn't like to gamble with his money and only invests in companies with predictable earnings. In the book entitled The Warren Buffett Way, Buffett was quoted telling some business school students in 1994 that:

I put a heavy weight on certainty. If you do that, the whole idea of a risk factor doesn't make any sense to me. Ri! sk comes ! from not knowing what you're doing.

In fact, Buffett is so certain about the future earnings of companies he invests in that when he estimates the stock's intrinsic value, he discounts projected cash flows at the same interest rate as risk-free long-term government bonds – no equity risk premium:

Buffett is firm on one point: He looks for companies whose future earnings are as predictable, as certain, as the earnings of bonds. A company's future cash flow should take on a "coupon-like" certainty. If the company has operated with consistent earnings power and if the business is simple and understandable, Buffett believes he can determine its future earnings with a high degree of certainty. If he is unable to project with confidence what the future cash flows of a business will be, he will not attempt to value the company. He'll simply pass.

To be clear, unlike some other prominent value investors, Buffett allegedly does attempt to value stocks via a discounted cash flow analysis, and is quoted as saying that short-hand valuations methods based on a snapshot multiple of earnings or book value "fall short." Nevertheless, his focus on earnings predictability underscores the importance of limiting valuations based on a snapshot multiple to only a select group of companies with persistent earnings that are growing at a stable rate.

"Normal" Earnings Must Be Isolated to Value a Stock

Okay, now that you have narrowed down the list of companies that are suitable for a valuation based on a snapshot multiple based on their predictable earnings, the next step is to isolate a company's "core" earnings – the "normal" earnings that are recurring and based on the company's business operations – not financial tomfoolery or one-time events. Even if you calculate the proper earnings multiple to use (i.e., the proper P/E ratio), that multiple will not be useful if applied to a bogus "E" number. 

In other words: Both the "P/E" multiplier and the "! E" base! number must be accurate for the stock valuation to make sense.

Standard & Poor's has developed a measurement of "core" earnings (Page 70) that:

focuses on a company's after-tax earnings generated from its principal businesses. Included are employee stock option grant expenses, pension costs, restructuring charges from ongoing operations, write-downs of depreciable or amortizable operating assets, purchased research and development, M&A related expenses and unrealized gains/losses from hedging activities.

Excluded from the definition are pension gains, impairment of goodwill charges, gains or losses from asset sales, reversal of prior-year charges and provision from litigation or insurance settlements.

That definition has a lot of accounting jargon that can confuse rather than clarify. BusinessWeek explains the concept more simply:

Core earnings represent the difference between the revenue of a company’s principal, or core, business and the costs and expenses associated with deriving that revenue.

A simple example would be a chain of retail stores. The core business is running stores. Look at the revenues and the expenses from those stores, and you can find core earnings. While many retail chains may buy and sell real estate, that isn’t their main business. Neither is running a pension fund or many other things that such a company may do.

S&P believes that for an equity investor to make an investment decision based upon a company’s reasonable earnings expectation, it’s necessary to understand how that organization’s core business will perform in the future.

When analyzing a company's income statement and balance sheets, one must extract the abnormal from the normal and isolate the core earnings.

Real-Life Example: Analyze the Financial Statements

Consider the financial statements below:

Note: Year ‘T’ corresponds to the most recent annual statement. ‘T-1′ and ‘T-2&! #8242; ar! e the previous two annual statements.

Income StatementTT-1T-2

Net Sales

$107,714

$107,257

$112,883

Gross Profit

$49,915

$47,671

$46,319

Operating Income

$18,745

$17,373

$15,974

Non-operating Income

$1,740

$3,514

$2,925

Interest Expense

$1,388

$2,068

$1,533

One-time Write-down

$4,989

$0

$2,750

Taxes

$6,400

$6,778

$5,998

Net Income

$7,709

$12,041

$8,617

Shares Outstanding

6,995

6,995

7,922

Earnings per Share

$1.10

$1.72

$1.09

 

 

Balance SheetTT-1T-2

Cash and e! quivalent! s

$8,819

$7,969

$4,094

Accounts Receivable

$13,317

$13,253

$12,412

Inventory

$24,168

$20,405

$19,900

Other Current Assets

$2,631

$1,492

$1,568

Total Current Assets

$48,935

$43,119

$37,974

Plants Property & Equipment (PPE)

$28,357

$25,233

$23,125

Accumulated Depreciation

$13,404

$11,810

$10,814

Net PPE

$14,952

$13,423

$12,311

Other Non-current Assets

$21,195

$27,064

$27,405

Total Assets

$85,082

$83,606

$77,690

Accounts Payable

$12,324

$11,549

$11,077

Current portion of LT Debt

$69

$2,153

$66

Other Current Liabilities

$4,193

$3,322

$2,883

Total Current Liabilit! ies

$16,585

$17,023

$14,026

Long-term Debt

$9,540

$9,607

$15,914

Other Non-current Liabilities

$9,348

$10,670

$9,885

Total Liabilities

$35,474

$37,299

$39,825

Total Equity

$49,608

$46,307

$37,865

Preferred

$982

$982

$982

Common Equity

$48,627

$45,325

$36,883

Book Equity Per Share

$6.95

$6.48

$4.66

The most recent annual earnings are $1.10 per share. A novice investor may simply decide to use this $1.10 figure as the base for calculating the stock's value based on a snapshot earnings multiple. But that would be a mistake because the income statement includes extraordinary items.

Convert Reported Earnings to Core Earnings

Specifically, two line items entitled "one-time write-down" and "non-operating income" must be accounted for to ascertain normal earnings. Adding back the write-down and deducting the non-operating income yields a core earnings number of 10,958:

Reported net income ($7,709)

–        Non-operating income ($1,740)

+ One-time write-down ($4,989)

= $10,958

Divide $10,958 by the 6,995 shares outstanding yields core earnings per share of $1.57, which is 43 percent higher t! han the r! eported number of $1.10!

If you perform the same "core" earnings adjustments to the two previous years of financial statements, the earnings per share numbers in T-1 and T-2 become $1.22 and $1.07, respectively. So, what initially looks like a company with volatile earnings and flat growth over the past two years ($1.10 in T vs. $1.09 in T-2), actually is a company growing "core" earnings steadily at a compounded annual rate of 20% ($1.57 in T vs. $1.09 in T-2).

"Margin of Safety" May Require that Growth Rate be Discounted Before Using as P/E Ratio

According to Peter Lynch, the P/E ratio should equal the earnings growth rate and stocks growing earnings between 20-25 percent annually are his favorite (not too slow and not too fast), so arguably one could multiply $1.57 by 20 and get a stock valuation of $31.40. But our calculated growth rate is based on only two years of changes, which is too short – Lynch describes the proper earnings growth rate as "long term" or "in recent years." Under neither of these characterizations would two years of earnings growth seem to suffice.

Furthermore, the three years of financial data in our example appear to be tumultuous ones for the company, with substantial "one-time" write-downs occurring in two of the three years. One needs to question whether write-downs truly are "one-time" in nature if they occur in a majority of the years being studied! There is also some funky recapitalization going on in year T-1 with long-term debt decreasing dramatically by 40 percent, shareholder equity increasing by 23 percent, cash balances increasing by 95 percent, and shares outstanding decreasing by 12 percent. This unusual financing activity is an additional reason to discount the company's growth rate in my valuation.

Because of the limited financial data and numerous write-downs, the valuation principles of conservatism and "margin of safety" require that the company's annual earnings growth rate of 20 percent be disco! unted by ! at least 20 percent, which brings the earnings growth down to a more believable 16 percent. If you use 16 as the P/E multiple for the company's current core earnings per share of $1.57, the stock's valuation is $25.12 – 20 percent lower than the original estimate of $31.40.

As it turns out, the three years of financial statements used in this example are from the real-life 1988-1990 financial statements of spirits manufacturer Brown-Forman (NYSE: BF-B). The actual stock price at the time the 1990 financial statements were released in August of that year was $23.25, which is 7.4 percent below my fair-value estimate of $25.12. But, based on a 12 percent discount rate and the stock's actual dividend-adjusted stock performance over the 20 years from 1990 to 2010, the stock's present value in August 1990 was worth $26.11, 3.9 percent higher than my $25.12 estimate, so my valuation estimate is narrowly situated in between the stock's actual market price (+7.4 percent) and the stock's actual intrinsic value (-3.9 percent). Not bad.

Anchoring Bias is the Enemy of Accurate Stock Valuation

To be fair, I calculated the stock valuation after already knowing what Brown-Forman's stock price was in August 1990, so my calculation is tainted by "anchoring bias." Would I have decided to discount the company's 20-percent earnings growth rate by 20 percent if I hadn't known that a 20 P/E would overvalue the company? I like to think so, but we'll never know.

A financial blogger conducted an experiment using the Brown-Forman financial statements above, whereby he provided the same financial data to two groups of stock analysts, except that he provided one group of analysts with no information about the stock's current market price while providing the other group with false information that the stock was currently trading at $87.12.  The analyst group provided with the false market-price information estimated the stock's value (on average) at $34, significantly higher (68%) than! the aver! age value estimate of $20.21 in the other group.

Conclusion: anchoring bias is real and explains why so many retail investors are willing to buy overvalued stocks – their valuation of a stock is tainted by its current market price. The Internet bubble of 1999-2000 proved that the stock market is not efficiently priced and market prices cannot be relied upon to reflect true value. Remember the wise saying of value investor Benjamin Graham:  "Price is what you pay, value is what you get."

Intrinsic value and market price often diverge and the way to make money is to buy stocks that have a market price below intrinsic value and sell stocks that have a market price above intrinsic value. Using market prices to determine intrinsic value defeats the entire purpose of value investing.

A 14% Return in Less than a Month

When one values a stock correctly and waits for an opportunity to buy the stock at a substantial discount to its intrinsic value, it can be a beautiful thing. Last month, an independent energy driller recommended in my Roadrunner Stocks small-cap investment service rose more than 14% on news that eight corporate insiders had bought thousands of shares worth of the stock. Given that the company’s revolutionary “Generation 6″ frac design is head-over-heels superior to the frac design of any of its driller competitors in the Eagle Ford Shale and Permian Basin, the stock’s outperformance came as no surprise to me or my Roadrunner subscribers.

My stock-valuation methodology is based on a little-known and proprietary system, similar to the one that made Warren Buffett, Peter Lynch and others rich. It's taken me 20 years to perfect and the system is complicated, but the results are crystal clear. You can get all of my latest research by clicking here.