Can Earnings Provide Relief?

The rally in stocks that started in mid-June has lost momentum this week, with the S&P 500 down more than 1% in the past three trading days. In my opinion, there are a couple factors weighing on investors’ minds right now.

First, concerns over a potential recession and subsequent Federal Reserve action continue to linger. The fact is the Fed seems determined to keep tightening monetary policy in an effort to curb inflationary pressures in the U.S., even if it’s to the detriment of the U.S. economy. So, we haven’t yet seen the full impact of their quantitative tightening program, and that has investors worried.

Second, the second-quarter earnings season is underway and disappointing earnings have weighed on the market. I don’t believe the results will be as bad as many fear. But it remains to be seen if better-than-expected earnings will be enough for stocks to get back on track right away. Remember, markets are always forward thinking, and some investors don’t think the second quarter will be the low point in earnings.

So, with these concerns, what’s next for the market? It would not surprise me to see the major indexes, as well as the Russell 3000 Value index, revisit their June lows, which would be a decline of another 4% or so. Now, with that said, I do not believe there is much additional downside on top of that.

In the meantime, many stocks, including the ones on our Buy List, have already discounted lower earnings and should do very well over the remainder of the year provided we stay out of a severe recession. Many of our stocks offer yields higher than long-term Treasuries, which have retreated again with the yield on the 10-year Treasury below 3%. Bonds are betting that economic softness could limit inflation and force the Fed to stop raising rates after the expected increase at the July meeting in two weeks. I believe that assumption is reasonable.

Overall, we have taken some hits with the market this year, but I feel confident the bulk of the selling is behind us. We just need to remain patient. I believe our stocks will generate solid long-term results from current prices, simply given low valuations, return of capital through dividends and share buybacks, and moderate growth from operations.

Morgan Stanley: Strength Through Diversification

On June 21, we added the financial services giant, Morgan Stanley (MS) to the Value Authority Buy List. The company was formed in 1935 after the Glass-Steagall Act forced JP Morgan and Co. to separate its investment banking business from the rest of the company. Since then, Morgan Stanley has grown exponential, with revenue of $59.75 billion last year.

Morgan Stanley operates three segments:

  1. Institutional Securities provides investment banking services, including equity and debt underwriting, and mergers and acquisitions advisory services. This unit also offers brokerage services for institutional investors, including equity and debt sales. It derives income from market making and proprietary investments, and corporate lending. This segment accounted for 50% of revenues and 60% of net income in 2021.
  2. Wealth Management offers brokerage and financial advisory/planning services to individuals and small- to mid-size businesses. Through its 2020 acquisition of E*TRADE, the segment also has a self-directed brokerage service and provides insurance products such as annuities, along with real estate loans. In 2021, this segment accounted for 41% of revenues and 31% of net income.
  3. Investment Management manages money in a variety of strategies and asset classes for institutional and individual clients. This segment accounted for 9% of revenues and net income in 2021.

The post financial crisis era has been very good to Morgan Stanley. With markets strong, earnings per share (EPS) increased from $1.25 in 2011 to $8.03 in 2021, with growth across all three segments of the company. MS also grew book value per share nicely in the period, increasing it from $31.42 to $55.12 even as MS paid a generous dividend. Book Value Growth is important in financials as the increase in net worth is a sign that earnings quality was high and the company has additional net assets to generate a greater amount of future earnings.

Although earnings fell in the first quarter of 2022 due to a slump in the company’s investment banking business as financial markets were hit hard, results did show some resiliency. EPS declined to $2.02 from $2.19 in the prior year period as revenues fell 5.7%. Flat revenues in wealth management helped to stabilize results in the quarter. Even before the financial crisis, Morgan Stanley wanted a bigger presence in fee-based retail investing, stemming from their acquisition of Dean Witter in 1997. Morgan Stanley continued to invest heavily in Wealth Management post financial crisis as it sought greater stability in earnings, and it paid off in the first quarter.

Morgan Stanley will report second-quarter earnings on Thursday. With the markets still slumping and its investment banking business declining, EPS are expected to fall to $1.54 from $1.89 in the second quarter of last year. While trading results can lead to quarterly volatility, I believe actual results should be relatively close to estimates.

My thoughts are if MS can earn $1.50 a share in a quarter with a poor environment, its earnings power in more normal markets is well above $6.00 a share. So, the stock is cheap at its current price, which is well below February’s high of $110. Once markets start to normalize, Morgan Stanley should do very well. Buy MS below $78. My target is $90. The 3.7% dividend yield will add to total returns.

Position Review: Second-Quarter Earnings Should Be a Catalyst

Cognizant Technology Solutions (CTSH) will report second-quarter earnings after the close on July 27. Expectations are for EPS of $1.09, vs. $0.99 last year, on a 12% increase in revenues to $4.92 billion, with continued growth in digital offerings driving the gains. The stock has not performed well since CTSH reported first-quarter earnings, as orders did not grow as much as some had anticipated. However, with the company selling for just 14.8X this year’s EPS estimate, little growth is already discounted in the company’s share price. Given the company’s recent consistent growth, I believe too much emphasis has been placed on one quarter of orders, which are often volatile. I look for the earnings report to be a catalyst for the shares. Buy CTSH under $80. My target is $95.

Fidelity National Information Services (FIS) will report second-quarter earnings prior to the market open on August 4, with expectations for EPS of $1.72, vs. $1.61 last year, on an 8% increase in revenues to $3.67 billion. Wage inflation in the company’s banking solutions business is expected to cut into profit margins. The stock has recently been weighed down by continued concerns of growing competition in the payments industry, as well as fears that a possible recession will reduce the number of transactions processed by the company. However, the stock remains very cheap at just over 13X a reasonable EPS estimate of $7.28 for the year, which assumes some slowdown and added interest expense from a recent debt offering. FIS is a buy under $110. My target remains $130. Keep in mind that the shares traded over $150 a year ago.

First Busey (BUSE) will report second-quarter earnings in the last week of July, with expectations for EPS of $0.55, vs. $0.53 last year, on a 9.6% increase in revenues. While loan growth should be good and interest margins will widen, higher wages will cut into profitability. Analysts will primarily be interested to see where credit costs are headed given some signs of a softening economy. However, I do not think we will see a meaningful increase in non-performing loans, and EPS of $2.20 this year is realistic. The stock is inexpensive at 10.5X this estimate, with an attractive dividend yield of 3.9%. Buy BUSE under $24. My target is $29.

Newell Brands (NWL) will report earnings in the last week of July, with expectations for EPS of $0.47, vs. a strong $0.56 last year, on flat revenue of $2.56 billion. Estimates for the company have been moving lower as it is expected to feel the impact of inventory reductions at major competitors like Walmart and Target, as well as be hindered by cost inflation. However, even if EPS estimates for the year come down even further to $1.70 a share from the current $1.91 a share, the stock remains very cheap at 12X the lowered estimate. Meanwhile, management’s efforts to streamline product offerings and reduce debt will pay off in the long-term. Buy NWL under $24. My target is $30. The 4.87% dividend yield will add to total returns.

Old Republic International (ORI) will likely report second-quarter earnings sometime next week, with expectations for operating EPS of $0.64, vs. $0.73 last year, on a 5.7% decline in revenues to $2.0 billion. The company’s title insurance business is expected be down sharply due to the current housing slowdown. However, the general insurance business should be fine, and the company could earn close to $2.50 a share this year, excluding losses from the decline in the value of the company’s investment portfolio due to the bear market in stocks and bonds.

The rise in interest rates will help investment income long-term, and at 9X this year’s EPS estimates, the stock is cheap. The fact that the stock is selling at book value with a 4.1% dividend yield will also add support for the shares. Buy ORI under $24. My target is $27.

Phibro Animal Health (PAHC) saw its fiscal year end in June, and the company will not report earnings until mid-August. The stock remains rangebound between $18 and $20 a share, as earnings will be flattish with strong demand for the company’s animal medicines and vitamins being offset by higher costs. With the stock selling for a little under 15X forward earnings, I am willing to be patient for the costs to subside a bit, at which point earnings growth should resume. Buy PAHC under $20.50. My target is $25.

Sonoco Products (SON) will report second-quarter earnings on July 21, with the company already pre-announcing a strong quarter. SON has guided for second-quarter EPS of $1.60 to $1.70 a share, compared to $0.93 in the prior year. That’s also approximately 30% above the $1.20 to $1.30 per share guidance given at the end of the second quarter. Strong demand and pricing are driving the improved results. Economic concerns continue to hold back the performance of SON’s shares. However, at the stock’s current price, I believe downside is limited in any mild recession scenario, and upside could be significant if the economy remains stable. SON is a buy below $65. My $75 target is only 13.6X a reasonable $5.50 EPS estimate for this year.

Target (TGT) has been trading in a range of between $140 and $150, and I think the stock could stay there until second-quarter earnings are released in late August. However, upside potential in the stock is significant if the company can readjust its current excess inventory position. Heightened inventories were a result of a misjudgment in consumer demand and not an indication of a loss in the popularity TGT gained with consumers during the pandemic. If the company can work inventories down this year, TGT can earn $12.50 a share next year, and my $187.50 price target should be achieved. TGT is a buy below $163.

On June 30, Universal Health Services (UHS) announced disappointing second-quarter guidance. EPS are expected to be between $2.05 and $2.15, compared to an unusually strong $3.76 a share last year and expectations for $2.80 a share. Continued high nursing costs and disappointing volumes in acute care, where COVID-related admissions from last year were not replaced by other procedures, drove the shortfall.

I believe the market was already expecting this announcement to some extent as the stock has been under pressure for a while. Still, it would have been better if management reduced expectations immediately following the release of first-quarter earnings rather than waiting. However, I think management is now on the right track, as guidance for the whole year calls for EPS of $9.60 to $10.40, which is more realistic and will represent a base for future growth. So, while I wish we waited for the “other shoe to fall” before buying UHS, I think the stock is currently priced inexpensively relative to the reduced guidance, and it should do well once the company shows operations have stabilized. My new buy under for UHS is $110. My new target is $130.