Keep Your Head This Earnings Season

Four times a year, companies that are publicly traded on major American exchanges have to report their earnings results. On those reports, Wall Street analysts and other investors judge the companies based on a handful of key factors, including:

• How the company did.
• The drivers of its success or struggles.
• What the company expects for the future.
• How believable the end-to-end story is.
• What the general market expected to hear before the actual information went public.

It's a complicated dance, and the results aren't always predictable. For instance, a company can deliver bad news and still rise -- or, on the flip side, deliver good news and drop. To paraphrase the great value-investor Benjamin Graham, over long periods of time, the market is a "weighing machine" that prices companies close to their fair values, no matter what the market does in the short term.

It's that time of the quarter again
Earnings releases are incredibly valuable, as they provide key data to shareholders to help them pin fair values on their investments. Even after earnings releases, the market may not always get a company's stock price perfect, but those releases often trigger reassessments based on the new data they provide.

For the real-money Inflation-Protected Income Growth portfolio, the time covered since last week's update featured several earnings announcements. Some results were good, and some were not so good, and while the market absorbed the news from each company's announcement, it didn't always react how you might have expected based on the headlines.

Raytheon (RTN +0.00%) reported strong earnings but wound up the largest loser on the week for the iPIG portfolio. Raytheon's substantial increase in profit from continuing operations to $1.87 beat expectations. Still, its reliance on tax benefits and steady guidance for the year suggest that the company's fundamentals haven't substantially changed.

Based on those fundamentals, last fall I estimated Raytheon's fair value at about $28.4 billion, and even after last week's drop, its market cap of $29.9 billion is pretty close to that level, making its valuation look reasonable.

On the flip side, fast-food titan McDonald's (MCD +0.18%) actually gained a bit in market value on the week, though it reported disappointing earnings and faces strong competitive headwinds. Still, the market wasn't expecting much, given McDonald's previously reported weak same-store sales. Add in some optimism from its stabilization plan, and you get the recipe for a modest gain despite bad news.

Earlier this month, I indicated that McDonald's stock was trading slightly ahead of my fair-value estimate but wasn't so high as to require a sell based on valuation. Given that the earnings release confirmed that the company's weak same-store sales were hampering earnings, that perspective remains consistent. McDonald's has been able to successfully reinvent itself in the past, and it will likely be able to do so again this time.

Somewhere in between the two, safety equipment maker MSA Safety (MSA 2.13%) lost market value on the week following disappointing earnings combined with confident-sounding guidance. When last I reviewed MSA Safety's valuation in February (it was then known as Mine Safety Appliances), it was trading slightly ahead of my fair-value estimate. Its market capitalization is now higher than it was then, but its weaker earnings raise questions of whether it can achieve the near-term 18% growth required to justify that fair-value estimate.

Texas Instruments (TXN 2.34%) turned in the strongest market performance of any iPIG pick that reported earnings last week. This was an example of a stock reacting the way you'd expect to stronger-than-expected earnings. The chipmaker's results beat expectations, and it guided a bit upward, which propelled shares to a decent gain.

One aspect that's encouraging for Texas Instruments' long-term health is that it has been actively shutting underperforming businesses, such as its wireless division. That focus on financial discipline and willingness to cut back when it feels it is no longer competitive suggests its leadership is willing to make tough choices to improve the company's overall health.

A cleansing confessional season
Every public company goes through its earnings confessionals, and the market frequently takes those releases as opportunities to re-evaluate what the businesses are worth. To paraphrase Benjamin Graham, over time, the market is a weighing machine, and earnings releases help the market find that fair value weight.

The companies in the iPIG portfolio are no exception. As of last Friday's close, the portfolio looked like this:

Data from the iPIG portfolio brokerage account, as of April 25, 2014.

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