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One of the few truly reliable indicators of a stock's long-term price is company earnings. For people who like charts, a chart of earnings and stock prices tracked over a decade or two will almost invariably show that the two are closely linked. That's why most investors get real het up about earnings reports.
The mechanical strategy we use here doesn't use earnings in its formula, although dividends, which also reflect earnings, are essential. Dividends tend to reflect past earnings and future earnings expectations but don't necessarily track current earnings very closely. U.S. companies try very hard to avoid cutting dividends. A history of unbroken dividend growth is the ideal. This is one of the keys to why the Fool Four strategy works.
That's because dividends take cash out of the corporate coffers, too. A company facing a true long-term cash flow crunch can't maintain a high dividend forever. So the theory behind all of the Dow Dividend-based strategies is that when a company maintains its dividend in the face of whatever current crisis is driving down its price, it is showing confidence that earnings will soon recover to the point where they can again justify the dividend payment. When dividends stay constant but the price drops, a stock has a higher dividend yield, and that higher yield and lower price gives it a higher RP value. Enough of that and the stock lands on the Foolish Four.
Wall Street typically reacts badly to news of a drop in earnings. Even a failure to grow earnings at the expected rate can devastate a stock's price, especially small growth companies. Our more stable Dow giants are less subject to earnings drops, but only by degree. The punishment for disappointing earnings can still be quite severe. When Procter & Gamble <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: PG)") else Response.Write("(NYSE: PG)") end if %> announced a drop in earnings and anticipated earnings on March 7, the market slashed the stock's price from $88 to $52, a 40% drop for a world-dominating consumer company that is still in the black. I feel like rubbing my hands and cackling with glee over the prospect of Proctor & Gamble landing in the Foolish Four.
Last week DuPont <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: DD)") else Response.Write("(NYSE: DD)") end if %> announced earnings had grown 29% in the first quarter of 2000 when compared to the first quarter of 1999. The company also announced it expects to continue growing earnings at an annual rate of 17% to 20% for the rest of the year. The stock dropped due either to the general market conditions, or to reservations about the company's ability to maintain that kind of growth -- which is a truly remarkable growth rate for a mature company. DuPont has hasn't had any long-term, sustainable growth for the last three years, so perhaps such skepticism is warranted. Then again, it's a Foolish Four stock and it's due for a turnaround.
Another company with stellar first-quarter earnings is 3M <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: MMM)") else Response.Write("(NYSE: MMM)") end if %>. The company announced an increase of 27% in first-quarter earnings compared to earnings a year ago, but wouldn't raise its estimates for the rest of the year, maybe out of fear of getting slashed if it couldn't meet those higher expectations. And yes, the stock is down since the announcement. What does one have to do to get Wall Street's attention? Maybe they should rename the company 3M.com, although that seems to be garnering mostly negative attention lately.
SBC Communications <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: SBC)") else Response.Write("(NYSE: SBC)") end if %> also announced earnings last week. First-quarter earnings grew 14% compared with the first quarter of 1999. SBC is actually up slightly since the earnings announcement, probably because its announcement showed huge growth in hot areas like data revenues and wireless and Digital Subscriber Line (DSL) customers. Maybe its recent dividend increase (up 4%) helped.
If you would like to see a glimpse of the future, AT&T has a lovely "guidance" statement online. Guidance is what companies call the information that they provide about expected future earnings. Sometimes companies provide guidance to the public, and sometimes they provide it only to certain analysts. AT&T's guidance statement is a model of what companies should be doing. See last week's special on selective disclosure for news of a proposal to make all disclosure public.
Of course, all the great guidance in the world can't make up for negative earnings growth and the prospect of lower growth in general. AT&T dropped 14% today when first-quarter earnings were announced. The company lost all its open disclosure points from me with a headline stating that first-quarter earnings were up 42%. But when you read the very first paragraph of the news release, you learn that the increase was based on figures before adjusting for one-time expenses. The adjusted and fully diluted earnings showed a 15% drop compared with year-ago earnings. Tsk, tsk.
Fool on and prosper!
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