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Dorsey: What to Watch in Earnings

Jason Stipp

Note: Pat Dorsey is the former director of equity research at Morningstar. He is now the president of Sanibel Captiva Investment Advisers.

Jason Stipp: I'm Jason Stipp for Morningstar. As earnings season kicks off, we're checking in today with Pat Dorsey, president of Sanibel Captiva Investment Advisers, to get his take on what should be on investors' radars.

Thanks for joining me, Pat.

Pat Dorsey: Always happy to be here, Jason.

Stipp: So, we're getting ready to see all the earnings report from companies for the fourth quarter of 2011. What broad trends are you going to be looking for? What do you think should be on investors' radars?

Dorsey: Well, one interesting question happening right now is tech spending, especially at the big enterprise level. Of course, we had that big warning, well, not warning but miss really from Oracle recently. Oracle is the quintessential enterprise software provider, big-ticket items, such as data bases. And there is a risk that demand for that may be slowing down, partially because of uncertainty in Europe. But also, as part of the stimulus package some years ago, basically gave companies incentives to make big investments in software and capital spending because they could depreciate it faster. So it's possible that pulled forward some demand, which would make 2012-2013 softer than the robust results we've seen for big tech companies like Oracle and IBM over the past couple of years. So, I think it's a big trend to watch, especially given how well those companies have performed.

Stipp: Also, we know that there are a lot of wildcards that are still out there, and a couple of them happen to be global in nature. Can you talk about what you'd be looking for in company reports to get some insight on some of the global problems that we are seeing?

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Dorsey: Europe is a big one, of course. There is no question Europe is in a nasty recession right now. It just started. Even Germany, which had been one of the most robust growers, has posted, I think, negative GDP growth for the most recent quarter.

Now, only about 14% of U.S. exports are to Europe, so it's not a killer. It's actually, believe it or not, less of an exposure than say the Asian currency crisis was or even the Mexican peso crisis. We exported more to Mexico at that time than we do to Europe right now.

That said, there is a big question as to where is the demand going to slow in Europe? Is it going to be businesses ratcheting down and battening down their hatches? Is it going to be consumers really pulling the reins in? We don't really know, and I think that will be a very interesting question to look for in the fourth quarter reports that come forward.

Stipp: Spin the globe around a little bit and you land on China, which I think in some people's minds could be ... well maybe it is or maybe it isn't the bigger issue, but you would say that China probably should be the bigger risk just because of how much of global GDP China accounts for?

Dorsey: It's certainly a bigger issue, because Europe is really large, but it's only been growing at a few percentage points. China, of course, has been growing at a much faster cliff. In fact, if you look over the past decade, fully one quarter the additional GDP this globe generated over the past decade came from one country, and that was China.

We've already seen some pretty serious slowdowns in orders for construction equipment, for example, in China, as it looks like the housing boom there is starting to slow. I wouldn't say it's a bubble that's been pricked, but it's certainly slowing down.

It looks so far--and it's early innings--that you're getting kind of a soft-landing scenario. Again, the data is very, very opaque, and I think that's why company reports are so critical to read, because you've probably heard that old saw about "there's lies, damned lies and statistics"; there is actually a fourth category, there's lies, damned lies, statistics, and Chinese government statistics, which is why often we get a more reliable picture of what's going on in China from the micro level of what companies are saying. So, I think that will be a critical area to watch.

Stipp: So, Pat, I want to bring this to the investment level. We do know that sometimes earnings seasons can create certain volatility; more information is released into the marketplace. Sometimes companies can become miss-priced based on news that comes out in their reports. As an opportunistic investor, what would you be looking for? What kind of opportunities may present themselves given the results we might see?

Dorsey: Well, there are a couple. One is that you could see some earnings gains for big U.S. multinationals slow because the dollar has been so strong. Of course that means it makes U.S. exports a little bit less attractive. So, you might see some hits on the currency front. At the end of the day, if a company takes a hit because the currency didn't go their way, but they still sold just as many widgets and they got just as good a price for their widgets, and that knocks the price down, that could be a nice little opportunity.

Also, I think that further noise out of Europe could be an opportunity. Should Greece default, and the bonds are certainly priced as if they will, should Greece, say, exit the euro, that's going to be a pretty nasty few days in the market. But from a longer-term perspective, if you are 3M or United Technologies or Microsoft, Greece going to the new drachma is not a fun situation, but it doesn't kill a company that large and that well capitalized. So if there's a general market downdraft based on something like that, I would view that as more of an opportunity than a reason to sell.

Stipp: But potentially there are some companies with Europe exposure that you would probably want to stay away from?

Dorsey: European banks, yes. Most European banks are much more levered than U.S. banks. Wells Fargo, J.P. Morgan, for example, are maybe eight or nine times levered. Deutsche Bank 30-35 times levered. So, personally, I would not be bottom fishing in most European financials ... There are some exceptions: Credit Suisse, for example, started getting rid of some of its toxic assets earlier than the rest and has a wonderful asset management and private banking franchise. So, for the adventurous, that might be an area to look in. But generally speaking, I think any institution that's levered and dependent on European capital markets is probably not for the faint of heart.

Stipp: So Pat, one last thing on Europe. So, it seems like there are two issues here: there are the issues of the financials, which obviously are connected to all of the default and the sovereign issues in Europe. But then also, as you were saying, Europe could be headed for a recession. So, how would you invest with those two thoughts in mind?

Dorsey: That's a great point. I think it's important to not just say "Europe is a mess." Disentangle it a little bit. Mess A is a recession. We've seen recessions before; we know what recessions are. It's called growth slowing down for a year or two. The world moves on.

The larger issue, or the more dangerous one, I should say, is if Europe becomes Lehman II, and you get this global credit shutdown that occurred around the time of Lehman's bankruptcy. So far that doesn't appear to be the case, because right now based on some fairly arcane metrics that I'm not going to try to discuss here, European banks are ... nervous about lending to each other. American banks are nervous about lending to European banks, but that nervousness has not infected the world globally. You're not seeing that nervousness in the American interbank lending system or the Asian interbank lending system. So what that indicates to me is that the odds of a global credit crunch are reasonably contained right now and that to me is really the fat-tail scenario that you want to have an eye out for.

Stipp: Last question for you as it relates to China. If we do see some signs of real slowing in China or hard landing in China, whether it's through earnings reports or other metrics that come out, what would you recommend for investors in a case like that?

Dorsey: That's really, I would say, keep your powder dry and wait and see, because the degree to which Chinese growth has been fueled by investment boom and especially massive lending during 2009--the Chinese stimulus package was basically Beijing holding a gun to the head of every Chinese bank and saying, please lend money--and of course, they said, "Yes, how much?" But never in the history of the world have loan books expanded that fast, and all the loans were money good.

So, the question is simply, how many are bad and how does that get taken care of? We have seen a bust in the Chinese banking system before, and it really didn't derail the country because it's so well funded that basically the government bailed out the banks and swept the assets under the rug and the world moved on. That could happen again, or not. But, again, the data is so opaque and the disclosure is so bad that I think it's very hard to make a call one way or the other.

Stipp: All right, Pat. Thanks for the insights on some of the global issues we are facing and also some things to keep on your radar for earnings season, and for joining me today.

Dorsey: Happy to be here, Jason.

Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.