Zacks Investment Ideas feature highlights: Caterpillar, Campbell Soup, Procter & Gamble, Kraft and General Mills

CHICAGO, June 9, 2011 /PRNewswire/ -- Today, Zacks Investment Ideas feature highlights Features: Caterpillar (NYSE: CAT), Campbell Soup Co. (NYSE: CPB), Procter & Gamble (NYSE: PG), Kraft (NYSE: KFT) and General Mills (NYSE: GIS).

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Q2 Profit Outlook

On May 31, with the S&P 500 at 1,345, I wrote "As we enter the summer months, I think the market will drift sideways to lower as the path of least resistance when catalysts are fairly balanced. When it's done resting, I believe we'll see the S&P 500 at the 1,500 level by this time next year."

As of Monday's close, we shaved 4.5% off in four trading days as a first leg of that "summer doldrums" scenario took hold. Do I think this is the beginning of a bigger decline? No, because even if we do touch the standard definition of a correction by falling 10% -- from S&P 1,350 to 1,200 would be an 11% drop -- my analysis tells me that the market will likely find strong support before that.

And the reason is as simple as the core ingredient of the winning formula we research and write about every day at Zacks: strong reported earnings and analyst estimate revisions that reflect continued strong profit growth for hundreds of US companies across multiple sectors.

Why is this a winning formula? Because it's what institutional investors -- be they equity mutual fund managers, pension plans, insurance companies, or hedge funds -- are looking at every day. They use analyst earnings estimates, whether those of their own research staff or that of sell-side providers, to plug into their equity valuation models and come up with fair value prices for stocks.

Forward Earnings Estimates = Forward Stock Valuation

Then they typically buy the strongest stocks with the biggest discounts to fair value. Where followers of the Zacks Rank stock rating system have an advantage over the big portfolio managers is that we crunch all the analysts' numbers every night into our proprietary quantitative model and come up with over 200 "strong buy" stocks that will likely be on the institutions buy lists, but which will take them many weeks to lumber into.

In this way, the model is not only built on the general investment buying (or selling) criteria of the big elephants in equity markets, it is highly predictive of stock prices because it targets which stocks specifically are most likely to receive that institutional money flow.

As earnings estimates rise, fair value increases and forward target prices for stocks rise. Obviously, this works in the reverse too, such that as earnings estimates fall, fair value decreases and forward target prices for stocks drop. From this valuation method comes forward P/E multiples that give money managers relative value comparisons between similar companies in like industries.

What has the earnings trend been that leads to optimism for the middle of the year? Net income growth for the first quarter was a very impressive 17% year-over-year. Granted, this was down from the wildly impressive 31% growth hit in the fourth quarter, but this drop-off is largely attributable to a failure of the Financial sector to repeat the massive growth it posted in the fourth quarter.

Slowdown Imminent?

It seems like everyone is talking now, especially after the weaker-than-expected GDP and PMI manufacturing data, that the growth slowdown is a given. But could it be merely a transitory period after very robust conditions out of the recession trough of 2009? Again, the place to look is within the earnings estimates.

According to Dirk van Dijk in his analysis "Still the Estimates Rise," written for Zacks on June 6, "Before the first quarter earnings season started, it was expected that growth would be just 6.7% for the S&P 500 as a whole, and 10.2% excluding Financials. Given the upward estimate momentum it seems highly likely to me that the actual growth in the second quarter will be significantly higher than the 10.1% (12.6% ex-Financials) now expected."

The next place to look under the hood in earnings growth trends is revenue and margins. You need either net margin growth or revenue growth to boost EPS.

First quarter revenue growth has also been very strong at 8.56%, up from the 8.31% growth companies posted in the fourth quarter. As van Dijk notes "Financials are a major drag on revenue growth, [and] if they are excluded, reported revenue growth is 10.49%, up from the 8.35% growth posted last quarter. Revenue growth is also expected to slow in the second quarter, falling to 4.96% year over year for the S&P 500 as a whole." But that number only slips to 8.75% if the Financials are excluded.

Margin Expansion is Key Now

There is no doubt that net margin expansion has driven earnings growth. Look at the severe cost-cutting and cash-hoarding that firms began in 2008 and 2009, which only continued into 2010. Caterpillar (NYSE: CAT) is a preeminent example of a cyclical company that slashed jobs and other costs as earnings went negative in 2008-09. But as anyone who has been around for a few business cycles can tell you, it's the cyclicals that most often rocket out of the recession trough with rapid earnings growth recovery.

And the fact is that margin growth is now starting to pull back in some sectors. In the aggregate, the S&P 500 will post positive margin expansion, but pressure is showing up in Consumer Staples like Campbell Soup Co. (NYSE: CPB), which currently maintains a Zack "Underperform" Recommendation. Analysts are closely watching input costs for foods companies as price increases in fuel, grains, and parts and machinery related to production squeeze margins.

While commodities rally and boost cyclical equity sectors like Industrials, Materials, and Energy, some of the more defensive names may suffer periodic earnings estimate downtrends when costs cannot be passed on to consumers and no new products add leverage. The opposite is true, of course, for the Energy sector, where revenues and margins are still expanding and creating record profits because costs are quickly transferred to end markets.

Procter & Gamble (NYSE: PG), Kraft (NYSE: KFT) and General Mills (NYSE: GIS) all sport forward P/E multiples in the mid-teens and PEG ratios near 1.8, signaling they may be near full valuation. All maintain a Zacks #3 Rank (Hold) and a Zacks "Neutral" Recommendation. But if a more pronounced market decline were to develop, money would still rotate out of cyclical stocks into these defensive areas for their reliable cash flow streams, profits, and dividends. For more detailed analysis of this sector, see the Zacks June Consumer Staples Stock Outlook.

Remarkable Revisions

The key metric we watch at Zacks to tell us the direction of corporate profits is earnings estimate revisions for individual stocks, and then how that data can be aggregated for industries and sectors. Another way to look at the whole market is through the revisions ratio, which measures total upward estimate revisions versus downward revisions.

Again, from van Dijk's report, "...the flood of estimate increases is impressive, with the revisions ratio sitting at 1.42. Total estimate revisions activity is now well passed its seasonal peak. Thus, over the next month or so, changes in the revisions ratio will be driven more by old estimates falling out of the four-week moving totals than by new estimate changes being made. The estimate increases are widespread, with the ratio of firms with rising mean estimates to firms with falling estimates standing at 1.59."

All this activity combines into a bright picture for earnings growth. Total net income for the S&P 500 in 2011 is expected to hit $910 billion, a 14.8% boost from 2010's $792.3 billion. This breaks down to EPS of $95.49 and a "working" P/E multiple for the year of only 13.6. And 2012 estimates are building expectations for the first ever crossing of the $1 trillion mark. This will put the EPS for the benchmark well over the $100 level for the first time at $109.41, for a forward multiple creeping below 13 on any EPS above $100 over the next four quarters.

The bottom line: If you want to know the direction of the stock market for the next quarter or two, keep your eye on earnings estimates for individual stocks, and how that builds across industry groups and sectors. Short-term volatility due to sovereign debt issues, commodity prices, and political battles will create trading opportunities. But the main undercurrent of corporate earnings is predicting substantially higher equity prices over the next two years as the expansion continues.

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