Home>Video>What We Can Expect From Second-Quarter Earnings

What We Can Expect From Second-Quarter Earnings

Fri, 5 Jul 2013

Morningstar's Heather Brilliant says investors could see a lot of market volatility this upcoming earnings season, but that could make for tremendous buying opportunities of quality names.

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Video Transcript

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. As we get ready for second-quarter earnings, I'm sitting down with Heather Brilliant, our global director of equity and credit research, to see what he expectations are for companies' earnings.

Heather, thanks for joining me.

Heather Brilliant: Thanks for having me, Jeremy.

Glaser: Let's take a quick look back at the first quarter. What did we generally think that earnings looks like then, and do you expect that kind of trend to continue as we get second-quarter results soon?

Brilliant: I think the first quarter was generally in line with expectations. There weren't a lot of huge surprises one way or another. We saw a lot of our fair value estimates start to go up after the first-quarter earnings, partially as we really looked at the cash flows the businesses have been generating and how we see things developing over the next year or so. So on balance, we saw the market go up during the second quarter, but we also saw companies, as they are reporting first-quarter results, see their fair values increase on balance.

Glaser: So let's take a look at some of the themes you're going to be keeping an eye on in the second quarter.  A big one has to be profitability. Profit margins were very high for a long time. Have you started to see those come in? Do you expect to see lower reported profitability in the quarter?

Brilliant: I think that it's a reasonable expectation that record-high profitability cannot continue indefinitely. We're a little bit less concerned with businesses that are exposed to the United States and a little bit more concerned with businesses that still have a lot of exposure to Europe, and especially to China. We've been talking about China seeing industrial production come down, and we started to really see that play out. We think companies that are more exposed to that will certainly be affected.

Glaser: What's the kind of sector-by-sector breakdown? Where are you more concerned that earnings could be little bit weaker, and where do you think there could be more strength?

Brilliant: So even though we think that valuations look somewhat attractive in basic materials, we're also concerned that second-quarter earnings could be not great. We expect to see some miners make announcements about having to cut back on expenses, overhead, or even cutting projects. And that really goes back to the idea that a lot of the commodity prices have come down enough so that miners are really going to have to be more scrutinizing of all of the expenses they incur.

Glaser: Who do you think is more likely to have a good quarter then?

Brilliant: Actually we think there is some opportunity in health care. Not that we think health care will come roaring back this quarter or anything like that. But on the margin, we're starting to see increasingly high cash levels on the balance sheets. We saw a deal Monday as a matter of fact. So you're starting to see a little bit more merger and acquisition activity going on in health care, and I wouldn't be surprised to see the stocks do well during the next quarter.

Glaser: When we think about cash on the balance sheet, like you just mentioned, for the last couple of quarters we've had some big announcements about lots of dividends, share buybacks, and ways to return that capital. Is that a trend that you'd expect to continue, or given some of the volatility we've seen, do you think companies are going to hold on to that cash a little bit tighter?

Brilliant: We do generally expect to see that continue, and of course, we always hope that companies that are going to buy back their shares do so when they are trading at a discount to intrinsic value, but you don't always see that, unfortunately. But we do expect that companies will continue to do buybacks and dividends.

Glaser: We talked about profitability a bit. But when you think about top-line growth--you mentioned that the U.S. might be a little bit stronger--are there certain areas that our analysts are really expecting to see a lot of growth, or is it going to be kind of relatively soft growth but that's just going to be what's expected?

Brilliant: Well, we do think that we're going to continue to see recoveries in both the auto sector and also within housing. So the interesting thing about housing is that, even as interest rates rise, we still think that there is enough demand and enough recovery in the housing market that we will see stocks related to housing do well and earnings coming in better in those areas, too. But on the other hand, businesses that are really exposed to refinancing can start to take a hit. As we start to see rates rise, refinancing usually stops very abruptly, and we are starting to see the signs of that. So we expect the second-quarter refinancing businesses will not be so well off.

Glaser: Let's talk a bit about valuations. For the first time in at least recent memory, there are no 5-star, wide-moat stocks at the moment [Editor's note: Since filming, wide-moat firm Enbridge has become a 5-star stock]. Do you think this says that the market is mostly overvalued and we could see some sell-offs during earnings? What do you think the market is pricing in as we enter earnings season?

Brilliant: I wouldn't be surprised to see a lot of volatility during this earnings season. I do think that people have very high expectations priced into quite a lot of stocks. Generally speaking, wide-moat or really high-quality businesses have been particularly run up during the first six months of this year. So I do think that if these stocks do not meet Wall Street expectations, the Street could be very quick to punish them. But we think that could really lead to some tremendous opportunities because they are great businesses fundamentally. So if you see somebody like a Microsoft or Intel miss their quarter, then we think that could be a really good opportunity to get into wide-moat names at a discount.

Glaser: What would be some other kind of wide moats for your watchlist if we do see this volatility?

Brilliant: I think there are a few that look pretty interesting. Novo Nordisk is actually a Europe-based health-care company exposed to diabetes. They make a lot of insulin, and they really benefit from skill within their business. We think it's a really interesting business, and it's in 4-star territory, so a small sell-off could lead to an opportunity. But also businesses like Facebook and Sanofi, another European pharmaceutical firm, cross the radar. And National Oilwell Varco is one we've talked about before, but is certainly an interesting stock that I think, if it sells off a little bit as a result of earnings, could be a great opportunity.

Glaser: Heather, I appreciate your thoughts today.

Brilliant: Thanks, Jeremy.

Glaser: For Morningstar, I'm Jeremy Glaser.

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