U.S. News

Slower Corporate Profits Shouldn't Worry Investors: Market Pros


Many big companies are lowering earnings expectations for the rest of this year, but that doesn't necessarily mean bad news for investors.

The reason: corporate profits will still be healthy--just not as robust as they've been in recent years. And some market pros think stocks are still relatively inexpensive when compared with projected earnings.

"For the casual observer, it looks worrisome," said John Massey, senior portfolio manager of large-cap growth portfolios at AIG SunAmerica. "But for market participants who have looked forward, it shouldn't be too much of a surprise. We think the economy is (still) strong fundamentally."

The more modest profits outlook runs across several sectors, from 3M-–viewed as an economic bellwether given the many industries it operates in-–to UPS, the ubiquitous package-delivery giant, and mortgage-maker Countrywide.

UPS blamed its lowered guidance-–now 6% to 10% earnings growth--on weaker industrial production, which translates into less package deliveries. 3M, where the product line runs from Scotch tape to roofing granules, said there appears to be moderating economic growth worldwide, though it may pick up in the latter half of this year.

Sectors Will Differ

Though overall growth in earnings will slow to the single-digits, some sectors will do better than others. Last year's star performers--such as energy--are expected to slow significantly, while healthcare and technology are likely to do better, money managers say.

Standard & Poor’s 500 companies have had an exceptional run of double-digit growth for the past four and a half years, where outsized gains in energy played a large role, experts say. Wha's happening now is simply a reversion to a more average world, where the series of interest rate hikes over the past couple of years is working its way into the economy.

“We are in for a transition,” said Michael Thompson, director of research at Thomson Financial. “The market has to get used to slower earnings growth. Expectations are being managed aggressively lower. That being said, these (forecasts) look almost too weak.”

It’s fairly common for companies to give themselves some wiggle room, he says. And while prognosticators will probably come to expect earnings growth of about 5% for this year, he said companies will likely end up delivering profits closer to 7%, in line with historical averages for the S&P 500 companies.

“You many see a little choppiness in the market in the near term,” Thompson said. “But this is when you typically see multiple expansion. And we aren’t starting from ridiculously high valuations considering the hyper-growth phase we’re” exiting.

In fact, the market could take a slight step backwards while investors digest fourth-quarter reports-–about 75% of the S&P 500 have posted results thus far--and adjust their portfolios around the lowered expectations. But for the most part, investment strategists and portfolio managers concur that stocks are fairly valued, especially in light of the earnings run over the past several years.

“Valuations across all sectors are relatively inexpensive,” said Christopher Hyzy, investment strategist for U.S. Trust, “They are attractive given the current environment.”

Hyzy expects profits for S&P 500 companies to rise between 6% and 8% this year, which would allow the market to rise in the low double-digits and boost price-to-earnings multiples to 17 from 15, he says. For longer-term investors, he believes stocks are attractively valued at current levels, but shorter-term investors might wait for a dip before diving in.

Choppiness in Markets

Still, the stock market’s strides are likely to be less smooth, and less vigorous, than the 13.6% gain logged last year, which is why many market watchers say it pays to be selective. The consensus is that large-capitalization companies will outpace their smaller brethren in 2007, while the technology and healthcare sectors will unseat last year’s top performers like energy.

“Large, well-capitalized domestic companies are going to do better in the second half of a business cycle,” said John Cannally, senior investment strategist for PNC Wealth Management and PNC Institutional Services’ $50 billion under management. He’s decidedly less optimistic about 2007 earnings growth with expectations for a 3% rise, but he still believes the market can move higher as earnings growth slows, similarly to the way it did in the mid-1980’s.

“When investors realize we still have a good four or five years of expansion, and that the Fed is out of our hair, that’s when price-to-earnings (multiples) can expand,” Cannally said.

And operations abroad are also a mitigating factor. While globalization has presented its own set of challenges – including emerging Asian competitors – they’re also benefiting from outsourcing as well as growth derived from emerging markets, experts say.

Revenue generated by the S&P 500 companies have climbed about twice as fast as the economy for the past three years, which Brian Gendreau, investment strategist at ING Investment Management, attributes to overseas growth. “I think some investors are underestimating the impact of foreign growth on earnings of U.S. companies,” he said.

“People still have a myopic view or traditional view of the S&P 500, adds Thomson Financial’s Thompson. “It’s still the benchmark for the U.S. economy, but these companies are becoming much more globally focused then they were even five years ago. The very nature of these companies are changing at an accelerated rate and they’re benefiting from markets outside of the U.S.”

Tara Siegel Bernard is a news editor at CNBC. She can be reached at tara.siegel-bernard@nbcuni.com.