Tuesday, July 27, 2010

Indexing Concerns And The Second Derivative Make This A Stock Pickers Market

One issue confronting investors at this point in the market cycle is the fact the growth rate of earnings on the S&P 500 Index are anticipated to slow going into 2011. Although operating earnings for the S&P 500 Index are projected to reach $92.19 per share, this level of earnings represents a lower rate of increase (the second derivative) than the earnings growth achieved in 2010.

From The Blog of HORAN Capital Advisors

For 2010 it is estimated that earnings will go from a -5% rate of growth in 2009 to a 22% growth rate in 2010. This represents a 27 percentage point positive swing in the rate of change in the increase in earnings on a year over year basis. It could be said the market's strong return in 2009 was forecasting this positive earnings change. The market does tend to be a good predictor of the future. As we now sit at mid year 2010, what are the estimated earnings for the S&P 500 Index in 2011 and what can be inferred from these estimates?

Although estimates show near record earnings of $92.19 for 2011 and a 16% increase over 2010 earnings of $79.53, this rate of growth is 6 percentage points lower than the estimated change in the growth rate of 27% in 2010. In other words, the second derivative of the earnings increase for 2011, or rate of change, is a negative 6%. Therefore, what investment strategy should investors pursue at this point in the market's cycle?

At HORAN Capital Advisors, we believe indexed large cap stock investors could be caught in this trading range cycle due to the negative second derivative of earnings, i.e. a negative rate of change in the growth rate. As a result, investors will likely achieve better returns, with less volatility, if they focus on individual high quality companies that exhibit a stable or consistent rate of growth in earnings when looking at earnings estimates for 2011 compared to the growth in earning for 2010. Those companies that can consistently growth earnings 10-15% over time are likely to provide investors with a more consistent return while assuming less downside risk as well. A couple of companies we own for our clients that satisfy this consistent or increasing growth criteria are Waste Management (WM) and Genuine Parts (GPC). As one can see by reviewing the below earnings charts, a steady or rising earnings per share growth rate is estimated for 2011. The 2011 EPS growth is near or better than the growth rate achieved in 2010. This represents just one of a number of variables we analyze, but it is certainly an important one.

From The Blog of HORAN Capital Advisors

One unpredictable variable is the market's potential reaction to the results of the midterm elections in November. What ever the election outcome, it could have a significant impact on sentiment for consumers and business.


Disclosure: Long GPC and WM


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