As Earnings Shrink, Here's Where to Hunt for Profits
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Though the economy is growing and the stock market remains near record highs, one key fundamental indicator has taken a sharp turn for the worse. Corporate earnings, which helped propel this six-year-old bull market, actually shrank in the first quarter. And if profits sink again this spring, as is widely expected, it would "qualify as an earnings recession"—the first since the global financial crisis, says Burt White, chief investment officer for LPL Financial.
With the S&P 500 trading at a price/earnings ratio of 18, which is about 20% above the historical average, diminishing profits are a reason to worry, but not to panic.
For starters, there have been three years since 1974 in which earnings failed to grow without the onset of an economic recession: 1986, 1998, and 2012, when equities posted double-digit gains. What's more, the biggest drag on overall profits has been energy, where analysts forecast a 58% decline in earnings per share through 2015. Strip out that sector and analysts predict a modest earnings increase in the second quarter.
You just have to know where to look for that continued growth.
See who wins cheap oil
While the oil market collapse has crushed energy companies, the decline in crude prices boosts other parts of the economy. With less money going into filling up their gas tanks, consumers can open their wallets a bit more. No wonder retail sales in March posted their biggest monthly gain in a year.
One industry that benefits from higher consumer spending and lower fuel prices is transportation. A smart way in: SPDR S&P Transportation ETF , which emphasizes cheaper airline stocks over frothier railroad shares. The portfolio's average P/E is just 14.9, vs. 19.4 for consumer stocks.
Focus on Revenue Growers
The profit boom in the years following the financial crisis had more to do with cost cutting than expanding sales. Eventually, though, "earnings grow because sales grow," says Pat Dorsey of Dorsey Asset Management.
S&P Capital IQ says the sector with the biggest revenue growth in the second quarter will be health care. The sector is "relatively immune to changes in the economy," notes Morningstar analyst Karen Andersen.
Still, health care stocks have doubled in the past three years, so you have to tread carefully. Andersen notes that biotechnology stocks look particularly pricey.
One exception is Gilead Sciences . With a P/E ratio of just 14—thanks to rapidly growing earnings—this biotech giant is priced 30% below its five-year average. This is despite an expected jump in hepatitis C drug sales that alone could add $14.4 billion to Gilead's revenues this year. Andersen sees earnings growing 11% in 2015.
Ride the Currency Waves
With the U.S. dollar up 22% in nine months, American firms selling to Europe and Asia are at a disadvantage. Not only are their goods more costly to foreign buyers, but they have to convert those sales back into dollars, deflating their results.
One way to avoid the fallout is to stick with truly domestic stocks. Firms (excluding energy) with most of their sales in the U.S. are expected to see 11% profit growth in 2015. Comcast makes only about 5% of its money abroad, vs. 46% for the S&P 500. Despite the nixed deal for Time Warner Cable, its earnings are expected to grow more than 11% annually for the next five years.
On the flip side, analysts expect European earnings to beat S&P 500 results in 2015, as the weaker euro cuts prices for the Continent's goods sold abroad. A cheap option is Vanguard European Stock Index , which charges just 0.26%.
Look for Growing Dividends
At a time of uncertainty over profits, a good sign companies are confident "in their future prospects" is if they boost dividends, says Haverford Trust chief investment officer Hank Smith.
A bonus: Rising dividends beat the market. Since March 2006, $100 invested in the S&P 500 has grown to $414. The same amount invested in the S&P 500 Dividend Aristocrats index, which tracks stocks that have raised dividends every year for at least 25 years, has become $526. For a solid dividend growth fund, go with SPDR S&P Dividend ETF , which is in our Money 50 list of recommended funds and ETFs.