Roundtable: Profit outlook is cloudy but stocks are cheap

— -- The outlook for corporate earnings next year is cloudy because of Europe's debt crisis and a slow-growth U.S. economy. Analysts polled by S&P Capital IQ expect companies in the Standard & Poor's 500 to earn $107.28 a share in 2012, up 8% from $99.01 this year.

Q: Is there a big risk that profits will tumble sharply? If so, what would be the cause? Would it take a shock to the system?

Doll: My vote: It has to be a shock. Most people believe that profit margins can hang in there. And if they do, and nominal growth is OK and we get a little bit of revenue growth, earnings will be OK. But profit growth will continue to slow. Earnings will be up around 16% this year and were up roughly 30% in 2010. It will probably be a single-digit number next year.

Bernstein: That is the key thing: Profit growth has been slowing. Could they tumble? You need a recession or a big shock. You don't usually see huge profit recessions without something causing that. And you know, eventually comparisons get easier and the profit cycle begins to heat up again.

Warne: Remember that the cost of commodities was really high the first half of last year, and those have all come down. So you've basically got a tailwind from lower input costs for any of the commodity-using industries. That will help earnings next year.

Q: Ann, you meet with a lot of managements. What's your take on earnings?

Miletti: Yes, I am on the road often, visiting with management teams of the companies that we invest in. And I see a lot of discipline. After living through the 2008-09 financial crisis, companies are operating with some level of fear about the global economy. But that discipline is really helping them protect profit margins.

We have not had a big enough recovery to create any bubbles in the U.S. since the financial crisis here. You are seeing a lot of discipline. That gives me a lot of confidence that companies are not going to do outrageous, silly things, and that they can sustain profit margins, unless there is a shock.

Q: So American businesses' get-lean strategy after the financial crisis is paying off?

Doll: This is part of the Corporate America story that most of us are seeing: the ability to get more out of the supply lines, the distribution chains, out of technology, out of their people. And they are still cutting costs. They are nipping and tucking. They are not going to stop as long as they have this fear that it might go bad due to (negative news) out of Washington, D.C., or Europe.

Warne: We are also seeing companies stay lean and mean. And that means revenue growth is dropping to the bottom line and creating really good earnings growth. (Analysts expect revenue growth to slow to about 3% in 2012 vs. growth of more than 10% in 2011, according to S&P Capital IQ.)

Stock prices remain relatively cheap

Due to all the fears, stock prices haven't really shot up very high considering corporate profitability remains robust. By at least one valuation measure, the price-earnings ratio, the broad U.S. stock market is selling below its historical average.

Is the U.S. stock market cheap?

Miletti: I think so. We look at each stock that we are going to buy, and try to determine the private market value of that stock, or what size check we would write if we were to buy the whole company. Stocks should trade at about 50% to 80% of that type of market value. When we analyze each individual stock in our portfolio and look at how much upside potential there is, typically there is very little upside for the current year when you get towards December. But (this year) we are seeing double-digit upside returns. That doesn't necessarily mean that I think the market can be up double digits next year. But it gives us a good idea that most companies are cheap and undervalued relative to private market value.

Bob, do you also see value in stocks?

Doll: Are stocks cheap? The answer always is, relative to what? And to make the simple comparisons, versus cash and U.S. treasuries, I think the answer is yes. I can buy the S&P 500 stock index (which yields 2.25%, according to S&P) and get a higher yield than cash (money markets are yielding roughly 0.50%, says bankrate.com). I can also get more on the S&P 500 than I can on a 10-year U.S. Treasury, which is yielding 1.90%). Stocks are pricing in that left tail risk (or worst-case scenario) with a huge probability.

The data show that P-E ratios are far from expensive. Is that another sign of value?

Warne: We would agree: stocks are cheap. The average historical price-to-earnings ratio, or P-E, is around 15. Today's P-E is 12.

A second (positive) is we are seeing more dividend increases in the S&P 500. Almost 300 companies in the S&P 500 have raised their dividends this year. That is way up from last year.

And if you look out over the next two years and you put together a portfolio of companies that have a track record of raising their dividends, what you have is companies with dividend yields of 3% or 4%. And the pay-out ratio (or the slice of profits paid out to investors via dividends) is now about 29%, compared to an average of 45% over the past 50 years. Companies that have a lot of cash have the ability to buy back shares but also to raise the dividends. And I argue that is a much better place to put the money.

So when will these low valuations matter again and act as a catalyst to push stock prices higher?

Bernstein: On a relative basis it already is. The U.S. is the strongest corporate sector in the world. U.S. corporations have been de-leveraging for the past six or seven years, and that is not true around the world. The U.S. stock market is flat this year but the emerging markets are down 15% to 30%. The U.S. has been outperforming the major emerging markets for four years. You have to look at how the U.S. is doing relative to everybody else. Surprise, surprise: We are doing just about the best.

Warne: Individual investors are pessimistic. They are seeing all the bad news from Europe and that is really clouding their view. Things are actually not too bad here, companies are doing well.

Doll: It is not just individuals. I was in front of 100 financial advisors (recently) and I made a comment about how well the U.S. stock market has been doing, and I showed the chart year-to-date. And I could see that they had …

Bernstein: No clue. They had no clue.