Some of Us Are Doing Just Fine

Profit news for the overall market isn't nearly as rosy as it is for these few companies, nor is it as rotten as you might think. During the fourth quarter, profits underlying the S&P 500 index fell 21% versus a year earlier. But that's mostly because the index weights companies according to their total purchase price, and the biggest companies right now are also the ones that are struggling the most. An equal-weighted look at the index tells a sharply different story. Profit for the median company, for example, increased 10% in the fourth quarter.

The culprits, of course, are financials, which have the highest sector weighting in the index. Banks and their ilk didn't just report a profit decline in the fourth quarter; they actually reported losses. That's because while some of us were betting on absurd home prices over the past few years, banks were betting on us. Stores rang up home-equity-funded purchases and sent us on our way. So companies that make and sell consumer discretionary items — stuff we want but don't need, cars and televisions, for example — have seen their profit fall only 9%, and from stellar levels at that. But financial companies gave us the money for those purchases in exchange for a pinch of interest and the opportunity to package, perfume and sell the loans. They were left with plenty of stinkers in inventory when buyers disappeared. Like surplus sushi, dodgy loans are best transformed into losses right away rather than held on to in hopes that demand will pick up. So banks have been aggressive with writedowns.

Some parts of the economy have produced enviable gains. Energy producers and distributors, telecoms and technology firms increased their profits by better than 20% late last year. That trend appears to be continuing so far this year but with less pain spread more broadly. Banks are believed to have taken the bulk of their losses, so their profits are expected to fall by less, about a third. Same goes for consumer companies. Overall profits for the S&P 500 will dip 7% if you use company-weighted numbers or rise 8% if you take the median. For the full year analysts are surprisingly upbeat, envisioning company-weighted profit growth of 14%.

There are two more moving parts to consider, and these say something less chipper. According to Zacks Investment Research, positive earnings surprises have outnumbered earnings disappointments in recent years by a ratio of 3 to 1. Companies have gotten good at guiding analysts a smidgen low; upside surprises over the past four years have averaged 3%. However, that ratio of beats to misses fell to 2.3 to 1 in the fourth quarter, and the average outperformance shrank to 2.8%. Zacks also points out that the ratio of earnings-estimate increases to cuts stands at 0.64, below the 0.80 cutoff for bearishness and indicative of three cuts for every two increases.

For stock investors stressing over the near-term performance of the market, these last figures are perhaps more important than forecasts. Underlying earnings growth matters over the long term, but corresponding adjustments in stock prices can take years to materialize. Earnings surprises say something much more immediate about stock performance. Dozens of studies over four decades have shown that when companies beat Wall Street's forecasts in a given quarter, they're more likely than not to do so again in the following quarter, and their shares tend to handily beat the market over the next year. Recent research suggests the size of a surprise is particularly important. A trio of professors from Stanford and the Universities of Utah and Michigan divided earnings surprises from 1988 to 2000 into 10 groups, ranked from biggest misses to biggest beats. They simulated buying the best decile while selling short the worst, setting up fresh long/short portfolios each quarter. Returns beat the market by an average of 14% during the year after they were created and by 20% over two years.

Upside earnings surprises are relatively scarce right now, but seeking out the biggest ones might be the best way to target stocks that are likely to outperform a sour market. It can also uncover companies that are benefiting from a spending slowdown. I recently screened for companies that have beaten estimates, on average, over the past four quarters and that rank in the top 25% of their industries for the percentage by which they beat them in their most recent quarter. Each company is covered by at least three analysts, and remaining earnings forecasts for this year had to have increased over the past month. Finally, I wanted average sales and profit growth of at least 15% apiece over the past three years. Six companies made the cut.

With money tight, consumers seem happy to forgo trips to the movie theater in favor of DVD rentals. Netflix has beaten earnings estimates by an average of 63% over its past three quarters. Competition for DVD rentals by mail has eased as Blockbuster, its chief rival, has raised prices. And on-demand service via the Internet, a business where Netflix faces more competition from the likes of Amazon and Apple, hasn't nearly caught up to DVDs in terms of size. Profit for Netflix is expected to grow 25% this year and next. Demand for Calvin Klein briefs has proven, shall we say, inelastic of late. Recession or no, the brand is taking market share in U.S. department stores and expanding overseas. That's flattering profit for Warnaco Group, which owns underpants rights to the brand and clears 20% operating profit on each pair, versus 7% for all its products, on average.

LKQ Corp. dominates the market for recycled car parts — those that have been stripped from junk cars. Demand for them has surged in recent years, as insurance companies are looking to cut costs on repairs. As the industry's only national distributor, LKQ is more likely than competitors to have requested parts in stock, analysts say. It has been busily buying smaller distributors over the past year, which investors seem to appreciate. The stock price has doubled in a year. Like Netflix, LKQ stands to gain from a spending slowdown, since drivers might opt for repairs over new models. Monsanto is profiting from soaring prices for corn, wheat, soy and more, brought on by big appetites in emerging markets and a shift to using corn for fuel in the U.S. High prices help the company sell more seed, pest-control sprays and genetic yield-boosting products. Profit for Monsanto is on pace to jump 44% this year and 22% next year.

Bucyrus makes big earth-moving machines, but while shares of most cranemakers have been sliding, its stock has soared. That's because cranes are used largely for commercial building, which has been far more resilient than home building but is eventually expected to slow. Bucyrus's machines, meanwhile, are used mostly for mining coal, copper, iron ore and the like — booming businesses, all. Orders are especially strong from China. About half of sales are for replacement parts and repairs. Finally, Disney stock was a dismal performer in early 2008, falling twice as far as the broad market. This despite a string of upside earnings surprises and forecasts for 17% earnings growth this fiscal year. Investors seem convinced that vacationers will look for cheaper options than the company's theme parks. Analysts point out that the parks contribute less than a quarter of operating profit, down from about half in the early 1990s, and that the company has added thousands of budget-price hotel rooms to lure bargain hunters.