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Great Earnings Hiding Top-Line Truth

When second-quarter earnings season is over, the results will show profitability blew past analysts’ expectations, but yet revenue barely scraped by.

S&P 500 earnings, taking into account the actual numbers for the 70 percent of the index that have reported and the estimates for those that remain, increased by 42 percent in the period, exceeding analysts’ expectations by a whopping 8 percentage points, according to numbers crunched by Brown Brothers Harriman. Meanwhile, revenue growth rose by 13.1 percent, just one-tenth of a percentage point above estimates.

“The quality of earnings is always based on revenues,” said Patty Edwards, founder of Storehouse Partners and a ‘Fast Money’ contributor. “If you have earnings, but not revenue, you cannot sustain it for long.”

Maybe that’s why the market has ended July on the downswing after roaring higher into earnings earlier this month. The results have been great, but investors are asking themselves how long this will last if it's just more cost-cutting. The report on Gross Domestic Product fueled that concern today, showing growth on an annual basis in the second quarter slowed to 2.4 percent from 3.7 percent the prior quarter.

Brown Brothers Harriman’s Charles Blood and his strategy team, who compiled the data, raised their earnings estimates for the rest of the year based on these results, but left their 2011 earnings figures alone on the belief margins simply can’t keep expanding.

“Note, however, that we are leaving our 2011 estimates unchanged at $90 to reflect our expectation of relatively slower GDP growth next year,” wrote Blood in the report. “Strong reports have been rewarded with a stock price increase while firms that fell short of their revenue outlooks have seen their stock price decline, regardless of their respectable bottom lines.”

Case in point: Colgate-Palmolive . Shares of the world’s largest toothpaste maker plunged Thursday after Colgate said sales increased just 2 percent to $3.81 billion. Analysts were looking for $3.94 billion, according to Thomson Reuters. Consumers are trading down to more generic brands, weakening demand for Colgate's products

Edwards is buying J. Crew because the retailer is still managing to increase end demand in this tough environment. Meanwhile, the money manager is staying away from the Gap.

“There are companies out there showing real organic growth,” she said. “They are just getting harder and harder to sniff out.”

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