Stock analysts consistently overestimate earnings growth. According to a 2010 study by McKinsey and Co., over the past 25 years analysts have predicted 12% average annualized earnings growth for S&P 500 companies. The actual results have been closer to 6%. That’s a recipe for investor disappointment. Both the Stock to Study from five years ago — HCC Holdings (ticker: HCC) — and the Undervalued Stock from 18 months ago — Hewlett-Packard (HPQ) are interesting case studies in overoptimistic forecasting, as both of these companies have badly lagged analysts’ estimates.
HCC Insurance Holdings
This nifty little insurance company traded at $31.42 when BetterInvesting Magazine’s Editorial Advisory and Securities Review Committee picked it as May 2007’s Stock to Study. HCC had increased its earnings per share 14.5% annually during the preceding 10 years, thanks especially to growing overseas demand. Analysts were calling for this high rate of growth to accelerate in the future, which would have been a stupendous achievement in the low-growth insurance industry. What happened instead was that earnings went into reverse. Insurance demand declined in the poor economy.
Meanwhile, declining interest rates made each dollar of written premium less profitable. Yet providers became reluctant to raise prices amid soft demand. HCC chose to give up some growth in favor of maintaining margin discipline. In a more typical interest rate environment, that decision probably would have proved savvy, but as interest rates have continued to grind lower and lower, less disciplined competitors have gained share without negative consequences so far. For HCC, the upshot has been flat revenue and declining EPS. 2007 was OK, with EPS up 15% to $3.38. Flash forward four years, however, and by 2011 EPS had fallen 32% to $2.30.
Given those financial results, the stock has held up reasonably well. At a recent price of $30.76, plus $2.57 paid in dividends, investors have earned 6% owning HCC over the past five years. By my math, that’s slightly (very slightly) better than the S&P 500 did during the same period. Currently trading close to its book value, HCC should be able to make some hay whenever the broader insurance market finally turns upward again.
Another case of analysts’ double-digit growth forecasts manifesting in declining earnings, matters have turned bleak for HP in the past 18 months, although the legendary technology company could always swing back into investors’ favor. Although market darling IBM has spent the last 10 years distancing itself from hardware in favor of providing services, HP has tried to double down on hardware and diversify into services. The result is a hodgepodge business without a clear strategy or obvious avenues for growth. November 2010’s Undervalued Stock recounted five recent acquisitions costing HP between $1.2 billion and $13.9 billion: Electronic Data Systems, 3Com, Palm, 3PAR and ArcSight. It’s hard to point to a savvy purchase on that list.
What all those acquisitions have done is pile a lot of goodwill and other intangible assets on the HP balance sheet. Intangible assets tend to decline over time, and the bleed rate is cutting into HP’s earnings. The consequences don’t necessarily have to be disastrous. If investors believed current results understated the company’s future earnings power, they could value HP based on alternative metrics such as revenue or cash flow. The old joke goes, “Accounting is neither a science nor an art; it is a state of mind.” Unfortunately, with HP there’s nothing positive for bulls to fall back on. Revenue and cash flow have both declined in recent quarters. When at least one of those metrics starts to improve, shares might have a chance to rally. Since being selected at a price of $38.45, shares have declined 35% to $25.01. Additional dividends of $0.60 provide little comfort.