Second-quarter earnings season is upon us. The markets aren’t expecting much growth. Core industrial names may not fare well, but thus far, big pharma is solid. We’re not making any changes to the newsletter portfolios.
By Brian Nelson, CFA
We’re off to the races with second-quarter earnings season. The markets aren’t expecting much, with the consensus for S&P 500 (SPY) companies to experience a 3% earnings decline, according to FactSet. If this happens, this would mark the first time S&P 500 companies, in aggregate, would have posted year-over-year declines since the first half of 2016.
The markets have rallied considerably since then, and despite the strong earnings expansion aided in part by corporate tax cuts, the 12-month forward P/E ratio stands at 17.1, now comfortably above both its 5-year and 10-year averages. Most of the support for the P/E ratio is not coming from earnings growth or lower risk assessments, but rather from a lower discount rate as the market is building in rate cuts from the Fed, despite a strong economy.
One of the better reports we’ve seen thus far has come from Johnson & Johnson (JNJ). The firm has been all over the news of late, and not for good reason, as the Department of Justice has now launched a criminal probe into the firm on claims that it may have known of the possible cancer risks of its talcum powder products. It’s near-impossible to handicap the outcome of situations like this, but we still like J&J. We expect any settlement to be reasonable, and we still believe shares are cheap. Read our latest note on J&J solid quarterly report here >>
We continue to like shares of Facebook (FB), and the firm’s settlement with the FTC over privacy issues has removed a key overhang on the stock. The $5 billion penalty sounds like a lot but it is truly a drop in the bucket for this $580 billion market-cap behemoth, one that generates gobs and gobs of free cash flow and stands on a huge net cash position. The social media giant is also getting a lot of flak from Congress regarding its cryptocurrency Libra, but we’re not concerned. Both Instagram Checkout and Libra are pure upside to our $230 per share fair value estimate.
On the topic of cryptocurrency, we believe that Facebook’s Libra will spell the beginning of the end for Bitcoin, Ethereum and others that are not backed by real assets and that do not have regulatory oversight. Importantly, Visa (V), Mastercard (MA), PayPal (PYPL), Booking (BKNG), eBay (EBAY), and even Lyft (LYFT) and Uber (UBER) all stand to benefit as founding members of the Libra Association. Libra isn’t necessarily a threat to Best Ideas Newsletter holdings Visa, PayPal, and Booking, but instead, it offers an opportunity, in our view.
Best Ideas Newsletter and Dividend Growth Newsletter holding Cisco (CSCO) has been in the news more recently, and not necessarily because it is paving the way for new all-time highs (even though it is). The firm bought one of its suppliers Acacia (ACIA), and while Cisco paid quite the premium, the purchase price isn’t too much to move the needle, $2.6 billion. We expect inevitable cost synergies as Cisco captures Acacia’s margins, and we like that Cisco will now have better control over its supply chain, particularly in efforts to meet the data needs of customers.
There were a few reports that we wanted to make you aware of with respect to the core economy. Industrial distributor Fastenal (FAST) noted in its fiscal second quarter report, released July 11, that “while general economic activity remained positive, (it) did see slowing in the second quarter of 2019 relative to activity levels experienced in the first quarter of 2019.” Fastenal also noted some headwinds on profitability from tariffs. We expect to update our report on Fastenal to account for its recent stock split.
Railroad operator CSX (CSX) sounded the alarm bell July 16 after it cut its full-year 2019 revenue guidance, and CEO James Foote called the current environment one of the “most puzzling” he has experienced. The rails offer a very important indicator when it comes to the health of the US economy, and in the context of Fastenal’s report, cracks are starting to emerge, at least within old industrial names. CSX now expects revenue to fall 1%-2% versus consensus expectations for a mid-single-digit increase on the year. The transports sold off hard on the news.
We include the Health Care Select Sector SPDR (XLV) in both the Best Ideas Newsletter portfolio and Dividend Growth Newsletter portfolio. We like having diversified exposure to benefit from the fantastic drug pipelines across the board. That said, President Donald Trump recently talked up a “favored nations” clause, an executive order that he believes “will ensure the US will pay lowest prices in the world for drugs.” The crux of the clause is that Medicare will pay the same amount as that of the lowest price of any nation, and while this is decidedly negative for big pharma and biotech, we continue to like the XLV, given the diversification benefits it provides within portfolio construction.
Further, big pharma appears to be very healthy. Johnson & Johnson’s second-quarter report and Abbott’s (ABT) second-quarter report, the latter released July 17, spoke to strong fundamental momentum. Abbott raised its full-year 2019 guidance for organic sales growth to the range of 7%-8%, while it upped its full-year forecast for earnings-per-share expansion. Full-year adjusted diluted earnings per share from continuing operations is now targeted at $3.21-$3.27, revealing double-digit growth. Abbott had positive things to say about FreeStyle Libre, MitraClip and Alinity, too.
We received a few questions as to why we include the Financial Select Sector SPDR ETF (XLF) in the Best Ideas Newsletter portfolio and Dividend Growth Newsletter portfolio. Within the construct of the newsletter portfolios, we may seek diversification benefits by adding ETFs in homogeneous sectors such as banks/financials and energy (XLE) (and healthcare, as in the XLV) that are driven more by macro considerations (the yield curve, energy resource prices, respectively, and the like – healthcare, by robust broad-based pipelines without the firm-specific risk of any one pipeline disappointment).
More recently, and as it relates to income, we talked about how the Big 6 banks can be considered yield plays in the June edition of the High Yield Dividend Newsletter. You can get a sample of that take here. Although the inverted yield curve may pressure net interest margins in the future, most of the big banks are diversified and generate considerable fee income. At the moment, we view the diversification benefits as sufficient to continue including the XLF as an idea within the newsletter portfolios, albeit at a very small position. Our latest notes on Wells Fargo (WFC), J.P. Morgan (JPM), and Citigroup (C) can be found here, here, and here, respectively.
Related: BTC, GBTC, DIA, QQQ, IBB
Distributors – Industrial: AIT, AXE, FAST, GWW, MSM, WCC
Railroads: CNI, CSX, KSU, NSC, UNP
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Brian Nelson does not own shares in any of the securities mentioned above. Some of the companies written about in this article may be included in Valuentum‘s simulated newsletter portfolios. Contact Valuentum for more information about its editorial policies.