Surprise! These Firms Beat Expectations, but Should You Buy?
With expectations set so low, many firms are handily beating estimates. These four stocks look like compelling values.
Our Picks
For months there was a bull market on bearishness. Analysts and commentators seemed to be trying to outdo each other by issuing increasingly dire forecasts. This pessimism was not completely unwarranted. The banking system was on the verge of collapse and possible nationalization, job losses were piling up, consumers shut their wallets, housing prices were plummeting, and the Fed was entering uncharted waters with its quantitative easing program.
Now that the economy has begun to stabilize, many observers have backed off from their most extreme doomsday scenarios. But there is still more than a fair share of pessimism permeating the investment community. This isn't so surprising. Analysts (and management teams for that matter) have little incentive to break from the pack and be overly bullish. Behavioral scientists have shown that people tend to feel more pain during loss than joy during gains. Companies and analysts would rather set low expectations and beat them, rather than miss an ambitious target.
This isn't to say that these conservative estimates are completely unrealistic. The economy is still sending out mixed signals; employment data is improving but weak, and consumer spending can't seem to get out of the basement. As Fed Chairman Ben Bernanke said on Friday, recovery will likely be slow and rocky.
Despite this gloominess, the major stock indexes keep hitting highs for the year. Some of this enthusiasm seems to be driven by the slew of positive earnings surprises reported this quarter. So why are so many companies outperforming? There are a few factors at work here. First, the bar was set exceptionally low making it easy for firms to jump over. Second, companies cut costs much faster than analysts thought possible. Few firms saw growing demand for their products or any organic sales growth. But by cutting staff and other costs, they were able to earn more than anticipated.
It is possible, then, that some of the firms that are beating expectations in this downturn are the ones nimble enough and flexible enough to react to a rapidly changing business environment. These are exactly the type of businesses that are likely to ride out the downturn and be able to take advantage of the recovery. Investors might be well served to look at earnings surprises, along with other fundamental valuation metrics, when seeking investment ideas. Adding the other, fundamental metrics is key, because overpaying for a firm--even one that has had positive earnings surprises--doesn't make sense.
To see a firm's earnings history, check out its quarterly financials page on Morningstar.com, where you can see by how much a firm beat or missed expectations. Here's an example for medical device firm Covidien.
You can also use our Premium Stock Screener to search for stocks that have beaten estimates last quarter, and that are rated 5 stars by our team of equity analysts. Here are some of the results that passed as of Aug. 21. You can run the screen yourself by clicking here. (Not a Premium Member? Give us a try with a 14-day free trial.)
Covidien 
A year after its spin-off from Tyco International , Covidien has substantially pared down its business to focus on the opportunities presented by its core medical device operations. The company continues to invest heavily in research, development, and marketing, which leads us to believe that Covidien's efforts to restore its pipeline--and ultimately its growth--will succeed.
Time Warner Cable
The strength of TWC's networks remains the key to its competitive advantage. The firm serves a bit less than one fourth of all households in the United States, offering packages of television, Internet access, and phone services that competitors in most areas can't match independently. AT&T (T), the phone company across about 40% of TWC's territory, is upgrading its network to offer TV services and faster Internet access, but we're skeptical of its network's ability to match TWC's. Verizon (VZ), which covers about 30% of TWC's territory, is undertaking a more ambitious network upgrade, but its plans are costly and time-consuming, and we expect the firm will avoid a price war to generate a return on its investment.
Carpenter Technology Corporation (CRS)
Carpenter Technology is a high-quality manufacturing company operating in a cyclical business. Despite the near-term slowdown in aerospace and energy infrastructure spending, Carpenter's cash-generating abilities and its healthy balance sheet make us believe that the company can comfortably wade through the downturn.
City National Corporation
City National's focus on affluent individuals and their businesses produces pleasing returns for shareholders. Despite the deteriorating credit environment and worsening economy, in the long run, we see untapped growth outside the bank's current footprint.