An earnings checklist for nervous investors

By Jim Jubak

"Tough comps" are sending stocks lower and investor nervousness higher.

It's not that earnings are about to tank in 2007. They're not. Standard & Poor's projects 8% year-to-year growth in operating earnings for the first quarter of 2007. But when compared with last year's 15% growth in earnings for the same quarter, 8% looks, well, like just not enough.

This kind of tough comp, short for tough comparison, makes it hard for 2007 to live up the expectations of more of the regular double-digit earnings growth that the market has seen stretching back to the second quarter of 2002. Just the possibility that it might come to an end in 2007 is enough to set the stock market fretting. And with the Dow Jones Industrial Average ($INDU) at a record high at the beginning of the year, those frets easily turn into "sell" orders.

Tough comps, are, in my opinion, the most likely explanation for the stock market's uncertainty -- up one day and down the next -- as we head into the heart of earnings season. In the rest of this column, I'll spell out the problem in more detail and then end with some suggestions for what investors should do about it.

Good news gone bad

Maybe you're familiar with tough comps because you invest in the retail sector. There the term is used to describe the worry that a company that showed great sales growth last quarter won't be able to meet that higher standard going forward.

For example, worry that American Eagle Outfitters (AEOS, news, msgs) is facing tough comps next year led me to sell the shares out of Jubak's Picks. It's not that I'm expecting the company to fall flat on its face in calendar 2007. But American Eagle, which reports on a January fiscal year, blasted the socks off in the year that ends this month with a projected 32% growth in earnings. Next year doesn't look shabby, except in comparison. Wall Street projects earnings growth of 11.6% for the next fiscal year.

But the tough comp problem is by no means limited to the retail sector right now. In the biotechnology sector, analysts have started to worry about how Genentech (DNA, news, msgs) is going to match its 80% 2006 earnings growth in 2007. The company did raise its guidance for 2007 by 11 cents to 22 cents a share on Jan. 10. But that still leaves 2007 earnings growth at just 25% to 30%.

Numbers like that may not send investors running to their computers to type "sell" -- the stock jumped 1.6% after Genentech raised its guidance. But it does send analysts who have a "buy" on the stock scrambling back to their models to see if they can generate enough potential growth to support price targets of $100. Will Avastin, the potential blockbuster drug, turn into real blockbuster and meet Standard & Poor's projection of $1 billion in sales by 2008? Is the 8% shortfall in Herceptin sales in the fourth quarter part of a pattern of disappointment (an odd word, I'll grant you, to apply to a company that just reported an 80% jump in earnings)?

But the extra scrutiny makes sense -- if you understand that, by some measures, the stock just got twice as expensive. On trailing 12-month earnings, Genentech on Wednesday traded at a price-to-earnings ratio of 41. With an 80% rate of earnings growth, that makes the stock dirt cheap, with price-earnings ratio/earnings growth (PEG) ratio of just 0.5. (Rule of thumb says any stock with a PEG below one is cheap enough to buy.)

But looking into 2007, with that 25% to 30% growth rate, the PEG ratio could potentially climb as high as 1.2. That's doesn't make Genentech an expensive stock, but it is enough to get those earnings models up and running on analysts' computers.

Slowdown and scrutiny

An atmosphere of greater skepticism that produces a more detailed look at how companies generate their earnings growth is indeed one of the major effects of a tough comps period. In the video attached to this column, I talk about the tough comp problem in the energy sector created by the decline in the price of oil from a high of $78 a barrel in July 2006 to $51.90 a barrel on Thursday. When earnings are going up faster than analysts can count, nobody worries, especially about disappointing exploration and discovery programs that have failed to add much to a company's proven reserves. So what if production is just barely creeping upward and reserves are actually falling as a company pumps more than it finds? The soaring price of a barrel of oil overwhelms all those worries.

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