The Illusion of a Cheap Market

Having trouble viewing this e-mail? Click here to view in a web browser.

Issue Number #1873

Investment U Today » David Eller questions some inflated earnings numbers... » Jason Jenkins on the latest rule of thumb for retirement savings... » Alex Green constructs a hypothetical "End-of-the-World" portfolio... The Illusion of a Cheap Market by David Eller, Investment U Contributing Editor Tuesday, October 2, 2012 Wall Street likes simple stories. If you can't fit an idea into an elevator pitch, it gets glossed over or distilled down into a one-liner. Popular use of the price-to-earnings ratio (P/E) for valuation is a good example of this. You take the price of the stock divided by the earnings of the company, and boom, you have a valuation that can be compared across companies and industries. But like any simple concept, it works until it doesn't. Right now the market looks fairly cheap, trading at a historically low P/E of 16, right? But what if the "E" isn't real? The cheap market may be an illusion... We've seen industrial bellwethers like FedEx (NYSE: FDX) and Caterpillar (NYSE: CAT) reduce full-year guidance, but large-cap technology companies have been meeting or beating expectations. ---------- Advertisement ---------- A Return of 68,000 Times the Investment? At an initial cost of only $5 million, one $7-billion Canadian company is now sitting on a discovery that "could be worth some $300 billion," according to Wall Street's top news reporters. Here's how you can take advantage of it before production begins in the fourth quarter of this year. ---------------------------------------- So how are tech market leaders like Cisco (Nasdaq: CSCO) and Oracle (Nasdaq: ORCL) meeting or beatings earnings estimates in the same economic climate? The answer is simple: They're using the cash on their balance sheet to "buy" growth. Cisco recently announced earnings that beat expectations by a penny and increased its dividend. Oracle also announced earnings that met expectations. But the quality of earnings declined because each used cash to buy back shares and artificially increase their earnings per share. When Cisco announced earnings in early September, people decided to look the other way. However, investors weren't as kind to Oracle, and this may be key to understanding how stocks will react as we head into 2013. Technology companies like Cisco have plenty of cash on their balance sheets to both fund operations and also reinvest in earnings growth - but not all industrial companies are able to do the same. As we get closer to earnings season, investors are caught between the opportunity to invest cheap (borrowed) capital in the markets and few safe havens to place it. Looking at the market as a whole, the S&P 500 is said to be trading at a 16 P/E. This isn't overvalued and may be considered cheap - but it could mask a nasty surprise. If earnings for 2013 need to come down by 20%, then the P/E of 16 is really a P/E of 20 (16/.8 = 20). Which is expensive for companies seeing slowing growth. FedEx lowered guidance from $7.15 per share to $6.40 per share. Caterpillar reduced earnings guidance from $17.50 to $15 at the midpoint, representing declines of 10% and 14%, respectively. These reductions are below the 20% we talked about in the last paragraph, but they're only for a partial year, not a full 12 months. Cisco, on the other hand, met estimates and guided to $0.46 cents for the coming quarter, which was a penny ahead of consensus. Oracle met consensus and guided in line with $0.61 for the coming quarter. Neither company gave full-year guidance, and a closer look at the numbers reveals that they bought the last penny of earnings. Oracle purchased $2.5 billion of stock, up from the $600 million it repurchased last year. If Oracle had the same share count as last quarter, it would have missed by a penny. Whether this is sneaky or good financial management, you be the judge. At least Oracle isn't alone. Cisco spent $1.8 billion to buy $0.007 of earnings per share, which was enough to bump EPS up to the Street consensus of $0.36. The scary thing from my perspective is the level of cash that each is using. Oracle spent more on share buybacks than it made in the quarter. Share Count Comparison         Oracle Cisco Net Income (in millions) $2,034 $1,917 New Share Count (in millions) 4,939 5,354 Old Share Count (in millions) 5,027 5,456 EPS 0.412 0.358 “What if” EPS 0.405 0.351 Cash Used for Buybacks (in millions) $2,559 $1,795 The question the pros are struggling with now is what to buy with the cheap money supplied by the Fed as we head into a possible earnings slowdown in the coming weeks. Companies like Cisco and Oracle have the balance sheets to mold earnings to match consensus, while weaker and more capital intensive companies will likely falter. It stands to reason that the companies meeting expectations for both results and guidance will see increase in valuation, but the companies that miss are likely to trade off substantially. This push and pull could cause substantial volatility for individual investors. But as the dust settles it could also create substantial opportunity if you stick to investing in stocks with good fundamentals and buy on dips. Good Investing, David Eller Click here to leave your comments on this article More from Investment U... The New Rule of Thumb for Your Retirement Savings There have been many popular rules of thumb about how much one would need to live comfortably during retirement. One common axiom was that you would need either about 70% or 80% of your pre-retirement income. So, if you made $50,000 right before retiring, you should need either $35,000 or $40,000 of income in retirement. These percentages depend on assumptions of how many expenses you'll still have after you stop working... Click here for the full story Get Some of Alex Green's Most Lucrative Research for Five Bucks People pay tens of thousands of dollars to get premium recommendations from financial bigwigs. But did you know that for the price of a grande coffee you can access moneymaking intelligence from one of the nation's top experts? Better yet, you could be combing through some of his best picks just seconds from now. All you need are a username and password... Click here for the full story How to Hedge Against Greek Contagion You probably saw the images last week of 50,000 protestors in Athens, some wearing helmets and gas masks and heaving firebombs at police. Demonstrations and violence also erupted in Spain. The grievances in both countries were the same. Times are tough and Spaniards and Greeks don't like the new austerity measures being imposed on them as a condition of remaining in the Eurozone. However, there are fiscal crises brewing not just in the European Monetary Union, but in Great Britain, Japan, Canada and the United States, as well... Click here for the full story This index has beaten the S&P 500 this year... Related Articles: Inventory Turnover: The Metric That Predicted Qualcomm's Earnings Warning How to Play Uranium's Coming Supply Shortage Leave Your Money to Your Heirs and Not Uncle Sam

~ SHARE INVESTMENT U ~ If you enjoy reading Investment U, why not share it with your family and friends? Simply send them this link, so they can sign up (for free, of course). Find the Print Version for this Issue, here. ~ QUESTIONS ~ Republish Investment U on your Website or blog for free. Learn how. Have a question for our editorial team? Contact us.

© 2012 Investment U All Rights Reserved Investment U · 105 West Monument Street · Baltimore, MD 21201 North America: 1 855 402 3939; Fax: 1 410 223 2650 International: +1 410 226 2070; Fax: +1 410 223 2650 E-mail: CustomerService@InvestmentUInfo.com | Website: www.InvestmentU.com Disclaimer Information and Privacy Policy Note: You are receiving this e-mail as a part of your free subscription to Investment U. Keep the e-mails you value from falling into your spam folder, Whitelist Investment U To manage your account or stop receiving Investment U, click here. To cancel by mail or for any other subscription issues, write us at: Investment U · Attn: Member Services · 105 West Monument Street · Baltimore, MD 21201 Nothing in this e-mail should be considered personalized investment advice. Although our employees may answer your general customer service questions, they are not licensed under securities laws to address your particular investment situation. No communication by our employees to you should be deemed as personalized investment advice. We expressly forbid our writers from having a financial interest in any security recommended to our readers. All of our employees and agents must wait 24 hours after on-line publication or 72 hours after the mailing of printed-only publication prior to following an initial recommendation. Any investments recommended in this letter should be made only after consulting with your investment advisor and only after reviewing the prospectus or financial statements of the company. You're receiving this message because you subscribe to the Investment U e-letter. If you wish to post a comment on any of our articles, or contact our Customer Service team, please see the instructions above. Do not reply directly to this e-mail, as your message will not be read or answered. Also, please keep in mind that securities laws prevent us from issuing personal investment advice to our readers. We're prohibited from answering such questions or giving that information via e-mail or over the phone. Protected by copyright laws of the United States and international treaties. This Newsletter may only be used pursuant to the subscription agreement and any reproduction, copying, or redistribution (electronic or otherwise, including on the world wide web), in whole or in part, is strictly prohibited without the express written permission of Investment U. 105 W. Monument Street, Baltimore MD 21201