Drip Portfolio Beware False Profits

More companies are seeing their earnings grow again, and the market is loving it. Rather than an increase in demand, however, much of the profit is coming from cost-cutting and accounting changes.

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By Rex Moore (TMF Orangeblood)
October 24, 2002

Just what in the world is going on here? The major indexes have gained roughly 15% over the past couple of weeks, and visions of a new bull market are dancing in our heads. Is it possible that nearly three years of pain have finally come to an end, and people can once again talk about stocks at cocktail parties without wailing and gnashing their olives?

Well, we could approach this question from a historical perspective. While it's true that many a September is sorry, apparently October surges like this one are built to last. USA Today says a lot of money managers tend to buy into such late rallies for fear of missing out on moves that can boost their end-of-year returns. Also, "five of the 10 post-World War II bear markets have bottomed out in October."

Of course, any rallies we saw the past couple of Octobers certainly didn't hold. Besides, I've never been one to trust my money to such "trends." Reminds me of baseball announcers who say things like, "Hey, how about this! Jones has a daytime batting average of .320 against left-handed starters of Latin descent on odd-numbered Wednesdays." Sometimes randomness plays a role, whether we like to think so or not.

What will sustain rallies, however, are strong earnings reports. In the long run, profits are what matter most. Yes, a stock can hang in there for a long time on the promise of riches, but eventually the company will have to produce real cash, or go out of business.

Thus, it's no surprise that the current rally has largely been fueled by better-than-expected earnings from some of the biggest names on Wall Street. Microsoft (Nasdaq: MSFT), 3M (NYSE: MMM), eBay (Nasdaq: EBAY), International Business Machines (NYSE: IBM), Johnson & Johnson (NYSE: JNJ), General Electric (NYSE: GE), Citigroup (NYSE:C), and Philip Morris (NYSE: MO) all came through earnings season with flying colors -- at least when compared to analyst estimates.

True growth?
Sure, a return to increasing profits is what we've all been waiting for, but many are questioning the sustainability of that growth. There are a couple of issues here.

For one thing, we're in a period where the change in the way companies account for goodwill is providing more favorable year-over-year comparisons. GE, for instance, reported a 25% jump in earnings for the third quarter. Profits still would have increased without the accounting change, but only by 14%. (It's important to note that these are paper changes only, and don't represent real cash. They do affect reported earnings, however, which are not the same as actual cash earnings, but are what most investors tend to look at nonetheless. For more on this concept, see Can't Beat Cold Cash.)

There's another, more important factor boosting corporate earnings these days. Because of the struggling economy, most companies have been forced to rein in spending and tighten operations. And since revenue - expenses = profit, cutting back on expenses means higher profit.

Take Hasbro (NYSE: HAS), for example. The toy maker was able to increase its third-quarter earnings by 10%, even though revenue fell by 8%. Meanwhile, Eastman Kodak (NYSE: EK) reported only a slight increase in third-quarter revenue, yet saw earnings jump over 200% thanks to "a lower cost structure and continued manufacturing productivity improvements."

But that sort of profit growth is not sustainable forever. You can only cut back for so long on advertising, research and development, employees, copy paper, pens, pencils, and toga parties for the CEO's wife. At some point, you begin to compromise your ability to stay competitive.

None other than Federal Reserve Chairman Alan Greenspan himself backs me on this one. "Corporate management cannot unendingly reduce cost," he told me over a game of checkers, "without at some point curtailing output or embodying new technologies through investment to sustain it." (OK, he actually said that during a conference speech.)

So, if you're trying to determine what a company's sustainable growth rate is, you should do all you can to separate earnings caused by trimming expenses -- "false" profits if you will -- from those attributable to an actual increase in business.

Fit and trim
Make no mistake, there's nothing at all wrong with management cutting back on unnecessary expenses and looking for ways to become more efficient. In fact, any business that hasn't done so in the past couple of years probably doesn't deserve your consideration. As painful as the recession has been, it has forced companies across the world to become better, or die. Once the economy rebounds, the leanest and most efficient will be the ones that take off, as investors reward their higher margins and strong earnings.

Blunt Ballmer
I'll close this out with a tip of the hat to Microsoft CEO Steve Ballmer. Thanks to him, we don't have to guess whether the software king will be able to sustain its 26% revenue growth. He told Australia's Nine Network that the blowout first quarter is "kind of a one-time anomaly," due largely to the company's switch to annual subscription-based pricing of its software. "We're not trying to say that we think the sales results of our first quarter will be sustainable."

Ballmer is certainly not averse to making bold and controversial remarks. You'll recall his most famous proclamation back in September of 1999: "There's such an overvaluation of tech stocks it's absurd," he said. "And I'd put our company's stock in that category."

Turns out he knew what he was talking about.

Rex Moore challenges Barry Bonds to hit without that stupid pad on his arm. At time of publication, he owned shares of Microsoft and eBay. You can view his other holdings, and the Fool's disclosure policy, anytime.

Drip Portfolio

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  Ticker Company Price
 Change
 Daily Price
 % Change
 Price 
  MEL MELLON FINL CORP (0.33) (1.17%) 27.87 
  PEP PEPSICO, INC. (0.01) (0.02%) 44.58 
  JNJ JOHNSON & JOHNSON (0.24) (0.41%) 57.71 
  INTC INTEL CORPORATION (0.53) (3.28%) 15.63 
  PAYX PAYCHEX INC (1.28) (4.38%) 27.95 
      
  Trade Date # Shares Ticker Cost/Share Price  Total % Ret  
 10/07/98 46.6655 MEL 35.00 27.87  -19.62%
 07/28/00 15.2182 PEP 45.57 44.58  -0.02%
 11/14/97 39.403 JNJ 42.32 57.71  37.60%
 09/08/97 59.9456 INTC 25.10 15.63  -37.10%
 02/05/02 10.275 PAYX 34.06 27.95  -17.95%
      
  Trade Date # Shares Ticker Total Cost Current Value  Total Gain  
 10/07/98 46.6655 MEL 1,633.06 1,300.56  -332.50 
 07/28/00 15.2182 PEP 693.53 678.42  -15.10 
 11/14/97 39.403 JNJ 1,667.59 2,273.95  606.36 
 09/08/97 59.9456 INTC 1,504.68 936.95  -567.73 
 02/05/02 10.275 PAYX 350.02 287.18  -62.83 
Cash:483.04 
Total:5,960.10 


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