Focus on profits, not economic growth

Headlines everywhere hail our heavy undercurrent of robust economic growth. Only kidding! But seriously, the second quarter is all but certain to be the seventh straight quarter of positive US earnings growth - and this quarter is high in almost all ways; beating expectations by a big margin. So it is somewhat ironic that all you read about is debt: PIIGS debt, US debt ceilings, too much government debt, etc.

When the whole world is near singularly focused on one issue, you almost never need worry about it because everyone else is doing it for you - a free service delivered to you gladly by fret mongers and deep-dive analysers. Markets tend to price these things in advance, making them into an eventual non-issue relative to the stock and bond markets. It's better to focus on things others ignore - like how much more robust US and global earnings are than folks expected or fully fathom.

And, yes, it's early in second-quarter earnings season - just 143 of S&P 500 firms have reported.

But it's promising, with 75% of firms having reported earnings above expectations, 13% meeting their expectations and only 13% missing targets. Typically (since 1994), just 62% beat. Over the past four quarters, 72% have beat. Analyst expectations remain too dour. That's a subset of people being too dour - which is bullish.

Average earnings growth for those reporting is 9.2% over last year - below the blistering pace of recent quarters, but recall we're now well past the easy comparisons of deeply recession-depressed earnings. In America, and overall globally, an almost never-reported-in-newspapers story is that GDP is at all-time highs any way you figure it. Strip out one outlier (Bank of America (BAC), which claimed a one-time, non-recurring expense tied to a lawsuit settlement) and second-quarter earnings growth improves to a blistering 15.2%.

Materials and Energy lead the pack sector-wise with whopping 47.8% and 36.2% earnings growth respectively over last year. The financials sector, unsurprisingly, is last with earnings down 29.4%; but nearly all that is Bank of America. Strip that out, and Financials earnings improve to 4.9%. That's positive and pretty shocking just two-and-a-half years after the depths of the credit crisis.

Telecom earnings so far are just flat (-0.2%) and Utilities earnings shrank -4.1%. These two classically "defensive" sectors typically fare worse relative to other sectors during economic expansion. So do Health Care and Consumer Staples, but Health Care earnings still grew 5.1% and Consumer Staples a healthy 10.8% so far. Consumer Discretionary earnings grew 10.7%, Industrials 15.6% and Technology 22.1%.

More firms must report and these numbers will change, but it doesn't paint a picture of widespread corporate doom. Quite the opposite.

The killer untold story here is revenue growth.

Through this expansion, headlines complained earnings growth was just "cost-cutting". That's true in part, but so what? Firms normally cut costs through and after a recession - it's the rational and correct thing to do. But the elephant in the living room is that revenues have in fact grown rapidly. Firms reporting so far have averaged 10% second-quarter sales growth. Only Financials firms reported a slight contraction thus far, with revenues down 2% on average. All other sectors reported sales growth.

After Financials, Health Care firms reported the worst sales growth so far-still up 5% over last year. Traditionally defensive Telecom, Utilities and Consumer Staples all averaged 8% sales growth, as did Industrials. Consumer Discretionary firms averaged 9% sales growth, Technology 13%, Materials 16%, and Energy 28%. Sales are booming.

How can so many US firms have consistently strong sales and earnings, yet unemployment remains high? It's normal. We see it after every recession - profit growth returns first. Firms have productivity gains from the recession and can make big profits off even smallish sales increases. Think like a CEO: Do you want to hire before profits have returned and sales improved markedly, or after? (Answer: After.) Jobs don't create that growth, it's the reverse. You have no real motivation to hire again until you fear future sales could be lost if you don't. Only after we get a prolonged increase in profitability and sales does employment start improving.

Why care about US earnings?

US firms typically report fastest and are good litmus test or proxy for overall global profitability. Over two years into this recovery - now officially an expansion - profitability continues expanding healthily. But amazingly, analysts remain too dour, underestimating corporate health. That probably comes from reading too much debt - fret hysteria. They would probably do better to watch old re-runs of Benny Hill instead.

Still, I'd bet eventually their sentiment catches up to reality. For now, celebrate corporate profitability with firms like these...

Though sentiment has improved some, I think investors will continue being surprised by stronger-than-expected business spending, which should aid some of the semiconductor equipment makers like America's Lam Research (LRCX).

It's a major player in the technology used to make advanced etch machines for integrated circuits. The company has lots of cyclical leverage, yet sells at only 1.8 times revenue and nine times fiscal 2011 earnings. Leading-edge technology at a bargain price.

Germany's Aixtron should see strong sales for its semiconductor deposition equipment for the same reason. The equipment is sold in 20 countries to most of the largest and high-end semiconductor firms. It sells at 11 times my estimate of this year's earnings.

New York-based Towers Watson (TW) is the world's largest employee-benefits consulting firm, spanning risk management, HR consulting, and actuarial, retirement and investment consulting. This is a moderate-rate growth firm, but it's in a class of its own. It's also too cheap at 1.4 times sales and 20 times likely 2011 June fiscal earnings.