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Looking into a crystal ball that works for stocks

If you’re looking for an accurate reading of a stock’s performance, says this advisory, analysts’ earnings estimates will usually show the way.

Companies call it “guidance” — reports on how they expect to do in the months ahead.

These days, those reports appear to be guiding most companies and their shareholders into a dead end. The phrase “weaker than expected results” seems to crop up with depressing regularity.

And this sets up a chain reaction that goes from analysts to investors. Instinctively, investors tend to avoid companies that broadcast declining earnings.

Are these instincts right?

“In these pages, we have told you many times to resist a natural inclination. We won’t do that today.”

The words are from one of America’s leading investment advisories, Dow Theory Forecasts.

In its latest edition, the advisory looks at two lessons that can be drawn from analysts’ estimates. On the way it pauses to make several “recommendations that investors cannot afford to ignore.”

Lesson number one is simple. When most analysts say a company’s earnings are going down, pay attention.

The trap door opens

“History suggests that when consensus estimates decline, stocks underperform,” concludes the advisory.

That is, when a group of analysts call for a company’s earnings to go down, watch out below. The trap door is opening for the share price.

This advisory illustrates with its own Quadrix system, based on Quality, Value, Financial Strength, Earnings Estimates and Stock Price Performance.

Tracking earnings estimates over the past five years, it discovered that the top one-fifth of stocks on the S&P 500 Index by Earnings Estimates score returned an average 7.1 per cent against 3.4 for the average stock.

Other studies going back even further confirm the trend.

Of course, the trend is going in a less enviable direction now. As of March 10, projected per-share-profits for the S&P 500 Index are down 12 per cent from last year’s levels.

No less than 87 per cent of the companies (and remember they are the biggest in America by market cap) saw their estimates decline over the past 13 weeks — with an average decline of 18 per cent.

But there are stocks fighting the trend.

Steadily rising estimates

One stock that has escaped the “earnings trap,” the advisory says, is Biogen Idec (NASDQ-BIIB). Its estimates for 2009 and 2010 have risen steadily over the past six months.

And this has happened despite a link between its multiple sclerosis (MS) drug Tybari and a brain virus. Although five patients have contracted the virus, sales of the drug are still rising.

The company is also in merger talks with another firm that has an MS pill, Acorda Therapeutics (NASDQ-ACOR). Plus its year of heavy spending on research and development could be ready to pay off as six new medications move into late-stage trials.

Analysts believe in the stock and so does this advisory. It makes Biogen a Focus Buy (best buy over the next 12 months) and a Long Term Buy (over the next 24 months).

Buying Spacely Sprockets

Lesson number two turns on buy recommendations. Many investors feel that analysts can be rather promiscuous with their “buys.” But how do these ratings actually turn out?

Dow Theory Forecasts looked at several studies that had conflicting results. Then it tried a test of its own. It looked at five years of stock coverage on the S&P 500 (large caps) and S&P 1500 (small, mid and large caps) with different levels of analyst coverage.

Here is the rather curious conclusion. Stocks covered by fewer than 10 analysts did better than stocks covered by more. “That makes sense,” the advisory points out, “when you consider that if 25 analysts cover a stock, most of the information about the company has probably reached the public domain, leaving less room for the surprises that drive stock prices up.”

It also answers the age-old riddle: how many analysts does it take to screw up a stock?

And buy recommendations can work. “Don’t misread this,” says the advisory, using a hypothetical stock from The Jetsons, “we do not recommend that subscribers load up on Spacely Sprockets just because Cogwell Investments gives it a Strong Buy rating.”

But quality stocks tend to shine through, the advisory adds, “and if a lot of analysts like a stock, there may be a reason.”

Energen (NYSE-EGN) a utility and energy hybrid, is covered by six analysts, and earns a buy rating from this group. Last year 88 per cent of its revenue came from natural gas, which suggests a big drop-off in the wake of lower commodity prices.

Yet some two-thirds of the company’s 2009 production is hedged at prices from 30 to 55 per cent above current rates. The firm has cut its operating budget as well.

Consensus estimates predict a per-share-profit decline of 20 per cent for Energen in 2009 followed by a 23 per cent rebound in 2010. The advisory makes it a Long Term Buy. It believes this is one firm that could exceed Wall Street’s expectations.

A word of warning

The advisory concludes with a word of warning. Given the level of panic it sees among investors, it feels compelled to point out that Wall Street analysts do predict a strong profit rebound in 2010. So hang on.

S&P 500 stocks could increase by an average 16 per cent. On the other hand, it adds, let’s not get all giddy. Analysts tend to be optimistic. A year ago, projections showed a rather better picture than we actually got in 2008.

“Don’t waste your time trying to predict what the economy will do,” says the advisory. Rather than trying to “play” the recovery, count on the market to react more quickly than you will.

Build an all-weather portfolio and trust in a combination of quality stocks and a forward-looking market to help you in the recovery.

And when consensus estimates say earnings are going up for Spacely Sprockets, we’ll be back to a bright future.