Through early June, EMS stocks have soared, rising 35% this quarter vs. a 22% gain in the Nasdaq, and more than offsetting the first-quarter relative shortfall to outperform the Nasdaq year-to-date by 5%. Equally impressive, year-to-date, the EMS group is up 27% on a market capitalization basis, marking the seventh consecutive year EMS stocks have risen at least as fast as a group of 50 leading technology hardware OEMs.
Since 1997, EMS stocks have tended to underperform the Nasdaq in the first quarter by nine percentage points and outperform in the second quarter by 11 percentage points.
We suspect the market may remain healthy through the end of the quarter given recent stock trends and the pressure investors are under not to miss an upturn after suffering such a long downturn. However, with window-dressing season past and this earnings season not expected to be especially robust, stocks may come under pressure, further attesting to the adage that "the best time to buy stocks is post quarterly earnings with the intent of trimming positions prior to the next reporting season as the economic recovery continues to be slower than expected."
In the past week or so, we have spoken to numerous companies and the general theme seems to be some form of: "Customers sound more optimistic, but we are not seeing it in hard, deliverable orders from our core business. However, because we are winning new business and taking share, we feel better."
Needless to say, everyone can't be taking share, and we ultimately need end-market demand to improve for existing consensus expectations to be met. For example, three contract manufacturers that are expected to have losses through midyear are also expected to report profits for the full year, according to First Call.
Furthermore, many of those reporting profits are expected to have much better profits. For example, in a recent mid-quarter conference call, consensus expectations for Flextronics are 32 cents a share for 2003 vs. an annualized rate of 24 cents in June.
And that brings us to the conundrum. EMS stocks have rocketed lately with an average 37% gain since the last reporting season began in mid-April (vs. 18% for the Nasdaq).
However, EMS stocks are not expensive vs. historical enterprise value/earnings before interest, taxes, depreciation, and amortization multiples, and, on a price-to-earnings ratio basis, are less expensive than a group of nearly 50 leading technology hardware OEMs, which are trading for an average of nearly 40x calendar 2004 earnings vs. 27x for EMS providers.
Hence, the biggest risk in the pre-earnings season may be from profit taking, but EMS stocks tend to overshoot the mark on the way up as well as on the way down. Hence, we would be apt to let positions ride a few more weeks, while slowly trimming holdings on further strength. If the market gets skittish, however, be prepared to move fast. Hopefully, past the earnings season, the fun will resume as EMS stocks tend to outperform the Nasdaq by seven percentage points in the third quarter.