Third-quarter earnings: Sectors to watch

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. We're on the verge of third-quarter earnings season, and I'm talking today with Matt Coffina, the editor of Morningstar StockInvestor, to look at some big themes that he will be watching throughout the earnings season.

Matt, thanks for joining me today.

Matt Coffina: Thanks for having me, Jeremy.

Glaser: One of the trends that you've talked about before is this difference between companies that sell more durable goods versus those [that sell discretionary goods]? Can you expand on that a little bit? Is that a trend you expect to continue in this quarter?

Coffina: That's a trend we've seen over the last few quarters. Companies that sell automobiles, appliances and larger items like that have been doing better than companies that sell more discretionary items. For example, we're seeing companies like Lowe's or CarMax which are two holdings in StockInvestor's Hare portfolio outperform companies like Wal-Mart, which we also own. I think that this is probably, more than anything, a result of pent-up demand from the recession. People held off on a lot of those big-ticket items during the recession, and now especially with a low-interest-rate environment, those items are only getting older over time. They need to be replaced eventually, and so that pent-up demand is working its way through the system.

I think that that is likely to be continued in the third quarter, but it's not a trend that will persist forever. At some point, the pent-up demand is going to be worked off, and assuming the economic recovery continues, we would hope to see more discretionary items also start to pick up steam over time.

Glaser: Another area that's been doing well other than durable goods has been internet advertizing. There are high hopes for this quarter, I know we've seen some big run-ups in stocks like Facebook in expectation of that. Do you think these hopes are justified? Do you hope to see some big numbers from the Googles and Facebooks of the world?

Coffina: We saw a huge shift in sentiment in the last quarter with companies like Google and Facebook. Investors were down on them earlier in the year worried that [the firms] weren't going to be able to navigate the transition of mobile computing to tablets and smartphones and effectively monetize their advertising on those platforms. Especially after Facebook reported just a blowout second quarter, investors have come around to the idea that mobile advertising will be just as profitable as desktop advertising over the long run.

I think that these companies are also positioned to do fairly well in the third quarter fundamentally. What I'm less certain about is what the stock valuations are already implying. I think hopes are running pretty high in a lot of these names.

Facebook, especially, is trading at a pretty steep premium to our fair value estimate, and so that does make me nervous that if the growth doesn't accelerate in the way investors are hoping for, then the valuations are baking a little too much optimism in at this point.

Glaser:  Sticking with the tech trends, poor PC sales had been another one of the big things we've seen over the last few quarters. Is that something that you expect to continue?

Coffina: Also, in the tech space, we're seeing older tech companies, such as the Microsofts, Hewlett-Packards, Dells of the world, really struggle to navigate that transition of mobile computing much more so than a Google or a Facebook is. Personally, I don't have huge hopes for some of these companies. I think PC sales are likely to remain depressed for some time as consumers put off that replacement of their PC, and instead choose to buy a tablet or something like that.

It's certainly going to be challenging times for companies like Microsoft. Microsoft has benefited from huge switching costs over the last two decades and those are being eroded in a way that they haven't seen in this whole time. That's reflected in our negative moat trend rating on Microsoft, indicating that the economic moat is getting weaker over time and that competitive position is deteriorating. It'll certainly be something to watch, but I'd say that I'm more nervous than anything for those companies in the short run.

Glaser: How about the valuations? Have those worries made some of those stocks cheap? Could this earnings season be an opportunity to pick up some of those names if they were to sell off?

Coffina: I think some of them are trading at modest discounts to fair value, but I think I would want a larger margin of safety before investing, given some of these negative headwinds. Depending on what happens after the quarter, [tech] would be a space to keep an eye on, but based on where we are now, I think I'd demand a larger margin of safety.

Glaser: This is one of the first earnings seasons that we're going to see after rates have risen a little bit out of the basement. What impact do you think that these higher rates or this rising-rate environment is going to have on various sectors?

Coffina: Interest rates can be tricky, and the effect in the short run can be quite different than what it is in the longer run. Thinking about financials, in particular, a lot of financials would benefit more from an increase in the short end of the yield curve rather than the longer end, and what we've seen so far is really just an increase in the longer end of the yield curve.

Companies like Wells Fargo or J.P. Morgan Chase, two of the names that we hold in the Tortoise portfolio, I don't expect those stocks to benefit from the higher-interest-rate environment in the short run. Actually the big banks are likely to be hurt. Because higher interest rates mean fewer people are going to be refinancing their mortgages, and we've seen a lot of the big banks start to lay off their employees that are involved in the mortgage side of the business because of this. Mortgage refinancing can react very quickly to an increase in interest rates, and I think that will probably be a headwind on the financials sector in the near term.

But longer run, we might see net interest margin start to recover for some of these financials. They've been depressed for so long because of the low-interest-rate environment. I think these companies come out ahead in the long run from higher interest rates, especially on the short end of the curve. It might just take some quarters before we start to see that show up.

Elsewhere, any company that has variable-rate debt could see a bit of a headwind as interest rates start to rise. I don't think that will be a huge factor especially for the wide-moat companies that tend to be relatively underleveraged that I focus on, but it is something to watch.

We can also see a pickup in merger and acquisition activity. We've seen some major deals recently. Probably the most prominent was Verizon's deal to acquire the 45% of Verizon Wireless that it didn't already own from Vodafone. But there's certainly a possibility that companies try to get in ahead of higher interest rates in the future and that we see more M&A activity in the near term.

Glaser: The Obamacare exchanges are set to open Oct. 1. Obviously, the impact of that won't be seen on earnings of this quarter. But do you expect to hear any commentary or anything you're watching for in the health-care sector to see what impact Obamacare generally is going to have on some of these companies?

Coffina: This is definitely big news in the health-care sector. But it really affects companies across all sorts of industries to the extent that companies have employees who they buy health benefits for, and a lot of those companies are exploring their options in the wake of Obamacare. We've seen some high-profile announcements of companies transitioning their employees off of traditional employer-sponsored plans in favour of either private exchanges, which are a private version of the public Obamacare exchanges or just letting their employees get insurance through the public exchanges where there will be generous subsidies available from the government.

I think, it's definitely a trend to watch. It could have effects on health insurance companies, for example. Certainly health-care companies will want to keep an eye on this. I don't think that the impact will be huge for the most part. When it comes to health-care companies, I think that most of them will benefit from Obamacare, as more people have health insurance who were previously uninsured and they start to ramp up their usage of health-care services. But it certainly could create some disruption in the short term, especially for the health insurers, as there is potential for some market share to shift as people start to explore their options.

For other companies, companies with low-wage workers, in particular, it could be a headwind going into 2014 to the extent that these companies have to decide--the employer penalties for not offering insurance have been delayed a year until 2015. But these companies are still going to be preparing now and deciding what they're going to do about their employee-benefit plans. We could see higher costs in some cases, or we could see companies start to drop their coverage. And certainly it will be interesting to watch. I think there is a lot of uncertainty here in the near term as we see how this plays out.

Glaser: Matt, thanks for the preview today.

Coffina: Thanks, Jeremy.

Glaser: From Morningstar, I'm Jeremy Glaser.