Smart Investing

Look out, here come the dreaded third quarter earnings -- or so says Wall Street.

It may come as no surprise to you, but I think the numbers will come in better then the estimates. I'm not hoping on a pie in the sky, I'm thinking about the facts and some earnings that have been released already. As always, I know I could be wrong -- it is very hard looking into the future. But I believe my logic is correct, and I will share that with you so you can come to your own conclusions.

The few companies that reported last month, two of which I hold in our portfolios, have beaten the estimates by a nice margin. The first company beat by a 13 percent margin, which in my opinion, is pretty good. But the second company beat by a 100 percent margin -- almost unheard of. In my portfolio, I follow 37 different companies that my clients have their money in. While I realize that two out of 37 make up only 5 percent of my companies, I believe other companies could follow suit as well. Why? A few different reasons.

First, companies have not been providing as much detailed investment guidance over the past year or so. Management didn't know how consumers would react to a slow economy, or how products would do in the most difficult economy since the Great Depression. So rather than being accused of being overly optimistic, management either gave very low guidance or gave nothing at all.

This was really hard for many analysts who are use to getting good, strong guidance from management. For the first time since 2001-02, analysts had to come up with some numbers for forward earnings with less information than they've had before. So guess what they did? That's right -- they, too, decided to be cautious and come up with low numbers to be on the safe side. So here we are sitting with what I believe are conservative earnings estimates.

Second, the economy did better than expected. No, don't get all up in arms and say the economy is still struggling -- I know that. But think back three to six months ago, and remember what the economy and consumers felt like. I think you would agree that while we have a long way to go, we have come off the bottom of the last six months.

Now you have a slightly stronger economy with businesses that restructured and wrote off their goodwill and cut back on everything they could think of to save their cash and earnings. No one really knows the true benefit that the companies will derive from all those cuts, but I do know that if you bring in a dollar of sales and your net profit margin is 10 percent, you would make 10 cents for every dollar you sold. But if management cut its costs and now the net profit margin is just 12 percent, that company will now bring in 12 cents for every dollar of sales. That's a 20 percent increase on the bottom line -- not too bad.

Add to that maybe sales climbed 10 percent -- keep in mind still down maybe 25 percent from the same quarter last year -- but still a 10 percent increase over the previous quarter or the expectation. That 10 percent increase in sales may fall right to the bottom line. Do the math and you now see a 13.2 cents profit at the bottom line, or a 32 percent increase over the expectation.

Please keep in mind the math is simplified, but I hope you are getting the point. Expectations may be too low, and the scary October may not happen because earnings estimates were just too low.

What if I'm wrong?

If I'm wrong, then I may be right in January or April. The economy is improving and companies have cut their expenses, and sooner or later that will show up on the bottom line. So don't get too inpatient or scared out of your quality portfolio because of some bad news coming out tomorrow or the next day. If you've done your research and you hold quality companies in your portfolio, you have nothing to fear. Let the management of the companies that you've chosen do their jobs to make you money going forward.