An earnings lesson

With nearly all firms reporting, the first-quarter average US earnings growth rate is 8.0%, hugely beating 3.2% expectations. Some analysts expected contraction. As impressive, revenues grew 5% - revenues being a more direct reflection of global demand.

Earnings growth through 2012 likely continues - in the US and globally - but don't be surprised if the growth rate keeps ticking down. Full-year 2012 growth will likely be slower than 2011's 15% - which is fine and normal.

Many view decelerating earnings growth as bearish - a sign of trouble ahead. Wrong! It's just a sign of a maturing cycle. Earnings growth is always gangbusters out of a recession. First, firms typically cut costs, which can make earnings surge on even small top-line sales increases. Then, year-over-year comparisons to recession-depressed earnings are easy.

Earnings growth is also normally broad-based then - with all or most sectors seeing growth. As the expansion matures, revenue growth may stay firm, but earnings growth often slows and is more differentiated. Comparisons get tougher. Firms have less room to cut costs without harming sales. And firms may spend to expand production, buy equipment, etc. That can ding earnings for a quarter, but can add fuel for future revenue growth - a smart move.

But even a quarter or two of negative earnings growth isn't an automatic sign of trouble. Since 1937, S&P 500 quarterly earnings have shrunk (year over year) 30% of the time (I use US data here for the longer history, but it's the same basic pattern globally). Most contractions, 63%, occurred during bull markets - and 12 months after, stocks averaged 11.4%. Slowing earnings is more common - quarterly earnings slowed 54% of the time, and 65% of those quarters are in bull markets. Stocks rise an average 13.6% 12 months after.

A great example is the big 1990s bull market. From the third-quarter 1993 US earnings peak, earnings growth decelerated, turning negative in third-quarter 1998. During that period, US stocks rose 148% - an annualised 20%. Huge! And that negative quarter didn't signal the end of the bull - it ran until early 2000.

Decelerating earnings growth is a sign of a maturing expansion and bull market - that the initial bull market thrust is over - and time to shift away from small, value stocks to big growth. Quality stocks - with good management teams and big, deep product pipelines. You want to buy now what people will pay up to buy later - firms that folks will perceive will deliver good results even if the economy slows. I think this expansion has room to run, but the idea is to buy now - before the crowd does.

Meanwhile, expect to see analysts remain dour, as even as decelerating earnings growth continues beating too dim expectations - and additional bullish factor.

US drugmaker Forest Laboratories (FRX) has a chequered past - too much of one big patent-expired antidepressant (Lexapro) - and 2010 criminal settlements and allegations. That's all in the past. The future is brighter with a great stream of 17 new and upcoming products for varying ailments, including antipsychotic Cariprazine and antidepressant Viibryd.

Forest is among the 100 largest global research and development (R&D) spenders. Thirty-five years ago I fathomed the price-to-research ratio - for buying good firms at less than 10 times annual R&D spending. FRX is a rare qualifier. It also sells for 18 times March 2013 earnings.

US-based videogame leader Activision Blizzard (ATVI) is pulling off a tough hat-trick. It continues to grow - though modestly - in a shrinking console-based videogame market. Top franchises include last year's number one top seller, Call of Duty: Modern Warfare 3, and massively multiplayer online role-playing franchise World of Warcraft, which has over 10 million paying subscribers.

ATVI is doing surprisingly well despite an explosion of iPad, iPhone and Android games. At 11 times trailing earnings I think the stock more than discounts the risk and underestimates the firm's strengths. It has a 1.4% dividend yield.

This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.