Is the earnings bar set too low?

Note: Pat Dorsey is the former director of equity research at Morningstar. He is now the president of Sanibel Captiva Investment Advisers.

Jason Stipp: I'm Jason Stipp for Morningstar. We're on the brink of earnings season, and we hope we'll have something more to read about than just the Spanish bond yield over the coming weeks. But is the cloud of pessimism over earnings really merited? Here with me to discuss is Pat Dorsey, president of Sanibel Captiva Investment Advisers.

Pat, thanks for being here.

Pat Dorsey: Happy to be here, Mr. Stipp.

Stipp: It seems like before every earnings season over the last couple of years, folks have been fretting, hand-wringing over earnings, [fearing] they are not going to meet expectations, and that we're going to finally see earnings start to falter after several quarters of strong business performance. It feels like the same thing again this time around. Do you feel like we're wringing our hands again, and we'll see actually a surprise from earnings?

Dorsey: Well, it certainly not going to be an upside surprise in terms of the results. I mean, the macro environment is definitely less pleasant than it was a few quarters ago. But the question becomes then, "What is discounted? What are the expectations?" Last I checked the expectations for aggregate earnings growth for the S&P 500 are either down 1% or up 2% or something mild like that. It's a low bar, I would argue, and you've got individual firms priced at 10 times free cash flow. I would argue that a lot of this uncertainty is well-discounted in equity prices.

Stipp: It's not like we've seen stocks running up in the past few weeks; in fact [it's been] quite the opposite.

Dorsey: Exactly. The only places you've had stocks running up are basically anything not tied to Europe. I think there is anything-but-Europe trade going on right now. So you see Costco. You see Chipotle. You see basically a lot of companies tied to U.S. consumer spending at, frankly, very high multiples.

Stipp: I want to touch on some of those areas of vulnerability in a moment, but one area I think that folks have been worried about is the technology space and concerns about some slowdowns there. What's your take on that particular sector? Do you think we'll see some more extreme weakness in technology than in other areas?

Dorsey: Certainly you're going to see a slowdown in Europe. You're a European IT manager, you've got a big IT budget and a lot of money to spend, and you're not sure if you're going to have a currency in six months. It probably induces a little bit of uncertainty, I'm going to argue.

However, again the question becomes "What is discounted?"

You've got Oracle selling at a 10% free cash yield. Cisco Systems selling at a 15% free cash yield. Autodesk now selling at a 10% free cash yield. Thursday morning, SAP, the big German software company, actually had a positive preannouncement. Now, [they had a] really messed up first quarter, so it could have just been the firm kind of pulling out all the stops to closing deals, sort of an SAP-specific thing. But, I think again weakness in Europe is reasonably well-discounted into a lot of enterprise tech.

Stipp: You mentioned before that a lot of this is expectations of what people are thinking is going to happen, what they've priced into the stock, and then what actually might happen. So earnings seasons can be periods where you get more information and depending on those expectations, the stocks can move around a little bit. You said that some areas that have been considered safe actually could be vulnerable to a little bit of a slip in earnings and it wouldn't take that much necessarily to maybe have the stock price take a hit.

Dorsey: Yes. So, let's look at consumer staples. We saw a huge warning from Procter & Gamble pretty recently. And that's because this is an area where if you get 6% revenue growth in a consumer staples company, you just knocked the ball out of the park. I mean demand for toothpaste or Tide just does not grow a whole lot from year to year.

So if you get a very small swing in margins from some pricing mistakes, foreign currency doesn't go your way, and there's a little bit of weakness in couple of your markets, suddenly that 5% revenue growth becomes 2%, and everybody goes bananas. And these companies are trading at 16, 17, or 20 times earnings for a Colgate or a Coca-Cola. That kind of a multiple, a high-teens, low-20s multiple, implies that you sir will hit the ball out of the park every single earnings season. That may not happen this time around.

Stipp: So what's really interesting about this is investors seem to just be swapping one kind of risk avoidance and then taking on another kind of risk, right. So they are taking maybe some Europe exposure risk off the table, but now they've got price risk because they are paying up for these safe assets.

Dorsey: Exactly. In investing there ain't no such thing as a free lunch. It's an old maxim, but it's very, very true. You don't get paid for nothing. You have to take some kind of risk to get paid in the equity markets. So you can take valuation risk, own Coke at 20 times earnings, and assume that a lot of these macro issues won't affect the firm. It will continue to do well, which is plausible; it's possible. Or you can take basically macro risk, with an Oracle, for example right now or an Autodesk, pay half the price you would for Coca-Cola, and accept more European exposure, accept more lumpiness in the revenue in the earnings stream. But you got to take some kind of risk if you want to get paid.

Stipp: And Pat, we also tend to, as investors, look at these earning seasons as potential opportunities where something might get mispriced. You mentioned a company to me earlier, that might be one to keep an eye on, but also just as an example of the kind of short-term action that can happen to a good long-term story.

Dorsey: So it's Qualcomm, which is probably a company reasonably familiar to a lot of viewers of this video. It has about three quarters of its operating income coming from licensing. It owns some key patents that are incorporated in all the 3G chips sold around the world. So the firm gets a piece between 3% and 4% of selling price of every smartphone sold around the globe. It also sells chips itself that go into a lot of smartphones and critically into both the iPhone and the iPad.

Now, I think it's a reasonably good bet that over the few years there is going to be more smartphone sold and there is going to be more iPads and iPhones sold. I'm OK with making that prediction right now. [Qualcomm] stock trades at about 7% free cash yield right now, but the firm is having some capacity constraints. One of its key suppliers, its foundry owner Taiwan Semiconductor, is having trouble pumping out enough chips to meet demand. So they are what's called on allocation. So it's possible this quarter that revenue may come in less than people hope because the firm wasn't able to get as many chips out of the door, coming from Taiwan Semi.

Now the last time I checked too much demand is not a bad thing. So, if the company takes a hit on this because it misses some expectation over the quarter, all you got to do is sit there and think: More or fewer smartphones over the next five years? Will Qualcomm be a part of that? Yes, and it looks pretty attractive to me.

Stipp: All right, Pat, well, if I can wish one thing for you, it's at least one day this earnings season, a Europe-free day, maybe some of those earnings headlines will crowd it out, but I can't guarantee it unfortunately.

Dorsey: I wish you could. A day without hearing letter E, C, and B would be a thrilling day.

Stipp: Well, we'll probably have to wait and see, but I'm not going to guarantee it for you, but thanks for joining me today.

Dorsey: Thank you, Jason.

Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.