In the long run, stocks that provide the best returns for shareholders have strong fundamentals driving their share prices higher. So when high-flying stocks start to show signs of weakness on the earnings front, smart investors take notice before the real problems start.
Staying sane in a crazy market
Over the past few years, investors have had a lot of trouble deciphering changing fundamentals. During the market meltdown, some companies took one-time charges related to the many problems that were going on at the time, including impairments on troubled assets and uncertainties about how to reflect asset valuations on balance sheets. At the same time, with the actual recession happening simultaneously, even those companies that were relatively unaffected by the financial crisis nevertheless saw weaker sales and earnings from the overall slowdown.
As a result of both of these factors, companies reported losses that in some cases were massive. Yet if you were investing for the long haul, it wasn't always clear whether you should treat those losses as a one-time catastrophe or as a sign of permanent change.
Conversely, when the worst of the financial crisis ended, companies saw a corresponding benefit going forward. Suddenly, companies were in the attractive position of getting to compare their latest quarterly financials against earlier periods that were unusually poor, making comparisons look deliriously rosy. That in turn led to the nearly unprecedented stock market rally during much of 2009 and early 2010, which pushed stocks up as much as 80% in a little over a year.
So now, as the economy returns to some semblance of normality and those easy comps fade into the sunset, what's next for stocks?
A return to fundamentals
Investors have gotten used to event-driven moves pushing their investments up and down. Whether it's the Fed's threat of quantitative easing or this week's elections, actions that aren't company-specific have dominated investor sentiment lately.
At some point, though, that will change. And when it does, shareholders in some stocks may realize that the fundamentals no longer support the advances they've seen in stock prices recently.
To identify some potential danger spots, I took a look at stocks that have risen at least 25% over the past year, but which expect to see earnings decline in their fiscal 2011 year compared to fiscal 2010. Here are some of the companies I found:
Current Trailing P/E
Projected EPS Growth 2010-2011
National Oilwell Varco
Source: Capital IQ, a division of Standard and Poor's. P/Es exclude extraordinary items. NM = not meaningful; Kodak is expected to go from a profit of $0.24 in 2010 to a loss of ($0.30) in 2011.
Are these winners tomorrow's big losers? The answer isn't as clear as it may seem from the numbers above. For many of these companies, expectations of falling earnings come as no big surprise. Frontier and CenturyLink, for example, are both rural telecoms whose legacy landline businesses make up a significant portion of their total revenue. Eastman Kodak has struggled to reinvent itself after the near-extinction of film-based photography. Falling profits are just a fact of life for some businesses.
In addition, even after big run-ups, most of these companies aren't trading at ridiculously high valuations. With Kodak, that's consistent with its rebuilding process. For SanDisk, it reflects the fact that memory chips have become essentially a commoditized business, subject to swings in the business cycle.
Finally, remember that analysts don't always prove to be right. National Oilwell Varco's dominance of its industry led fellow Fool Anand Chokkavelu to conclude that analysts expecting negative growth in coming years weren't especially credible.
In an ideal world, the best companies would see their financial results move upward in a straight line. But in the real world, results bounce around, with gut-wrenching down periods followed by dazzling quarters of strong performance. Trying to gauge a company's fundamentals based on a quarter or even a single year is a fruitless endeavor.
Although you should definitely keep a close eye on stocks with falling earnings, you shouldn't just automatically sell them. Sometimes, doing so will mean getting out at what proves the worst time.