The Importance of Expectations

 | Oct 21, 2013 | 1:04 PM EDT
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Get those expectations down no matter what, and you have a spring-loaded situation. Don't rein them in, and you have a debacle of the first order.

Many people were mystified by how a big-capitalization stock like General Electric (GE) could bounce, given the lack of top-line or bottom-line growth. Earnings per share were flat. Revenue was down a tad. How can that be a buy, yet the stock is off to the races. How can that be?

Pretty simple: The company's stock trades on expectations, not earnings, it trades on orders, not sales, and you had great news on both fronts. General Electric saw orders up an outstanding 19%, including a 22% surge in growth markets as well as an outstanding 17% increase in Europe. The margins -- what's made on sales -- were also up very nicely: The 120-basis-point margin expansion was breathtaking for the analysts who cover this stock. Aviation, power and water, locomotives, even oil and gas, which had execution issues, were terrific.

But the really good news was the absence of bad news in the GE Capital business. We had become conditioned to expect that the biggest earnings driver at General Electric was cats-and-dogs mix of real estate, banking and credit cards that was GE Capital. Here's a division that was originally meant to finance the sales of big capital goods, not unlike what Caterpillar (CAT) has for its big equipment sales. But over time, GE Capital became the principal source of earnings. In fact, the divisions that made actual things took a back seat to the company's finance division.

That was terrific when finance was a terrific global way to make money. It turned horrendous when the world went south and we learned that General Electric was a huge subprime lender globally as well as a large banker and real estate owner in Europe. When things got bad, General Electric tried mightily to maintain its dividend and put up a face that it was, truly, an industrial that had stumbled, and not a finance company that had invested in terrible pieces of paper to make its earnings and needed the help of the federal government to finance its commercial paper.

As the economy turned down and the prospects of a quick recovery went out the window, General Electric slashed its dividend and became a company that was much rumored to be needing a bailout. The stigma stuck with General Electric, and that is why it has not traded as well as many of the other industrials. In fact, it traded more like Citigroup (C) with a hard goods arm.

Now General Electric is putting that curious legacy behind it. The company is shrinking the capital business to where it will, once again, be an adjunct to real businesses or aerospace, power and water, appliances, locomotives, healthcare and oil and gas.

Also gone are the days when the earnings, when the company had them, seemed based on taking advantage of the tax code. That's something every company has a right to do, but you can't expect the earnings to be appreciated the way actual sales would. We don't want clever tax avoidance from a company. We want growth.

Finally, General Electric had set the bar low through a series of endless disappointments, with some division or another reporting sluggish growth and Europe providing a terrific reason to sell. That's done, too. Now there's accelerating growth and a belief that the November meeting about GE Capital will be about a further reduction of that division's mental drag on the institution and perhaps more disposals shrinking it even further. Then in December, CEO Jeff Immelt will hold an analyst meeting. Last year, that meeting was truly terrible, because Immelt showed an uncharacteristic weariness about the company's prospects.

That sure no longer seems to be the case. And that is how General Electric can be re-rated by Wall Street from a so-so financial to a potential industrial turnaround.

The re-rerating can be a double-edged sword, as we can see from the disastrous quarter from Stanley Black & Decker (SWK). Here's a company that, unlike General Electric, had let expectations get well ahead of the story. If General Electric seemed bad on the surface, Stanley Black & Decker looked terrific until you realized that the gain had to do with a tax change. Stanley Black & Decker turned out to be a bungling of immense proportions, because the company had failed to telegraph how poorly it was going.

The chief culprit? The security division, notably Niscayah, which it bought for a billion dollars a couple of years ago. On the call, the company was abject about not doing enough due diligence before the acquisition, because it was a competitive situation where Stanley had to move fast.

It moved too fast, and it turns out the quality of earnings and the management team were far weaker than thought. This plus the weakness in government business -- hmm, didn't know the company, known for its hand tools, had that much government business -- led to drastic estimate cuts and a huge fall in the stock, as analysts and investors were shocked.

You could tell that most people were in the stock not for the security division but for the do-it-yourself tools, which were very strong. People had been owning the stock because Home Depot (HD) had spotlighted tools as a strength, but the rest of the business was so weak that it didn't matter. Plus, the company gave you no real hope of any improvement anytime soon. For some it sounded as though a write-off of the acquisition could be in the offing, although that wasn't quite evident from the call.

Unlike General Electric, which had continually made excuses or cited weakness in the environment ahead of the quarter, Stanley Black & Decker had led people to believe that things were at least somewhat better than expected, and the stock had been one of the best performers in the home-related group.

Turns out it wasn't home-related at all. The parallels to the old General Electric are eerie. People had deserted General Electric for several years because it had become what many thought was a second-rate finance company with a first-rate industrial business. Stanley Black & Decker was a first-rate hand tool company with a small, thought-to-be-irrelevant security business.

Now that GE is back to being the General Electric corporation, it can trade much higher, perhaps as high a $30, as it takes money from other industrials that are doing better but have less leverage. Meanwhile, Stanley Black & Decker will do nothing unless an activist storms the gate, urging a breakup of the company.

Stranger things have happened. I don't think that Stanley Black & Decker would be as bad as it was last week, an $89 to $74 pummeling, if somehow it had signaled that all was not well. But the same thing goes for General Electric, where many were prepared for still one more downbeat report from Immelt and company. Instead, we have ample hope for an even better fourth quarter and a terrific 2014, something that will be spelled out at the November finance meeting and the annual December meeting. General Electric has become a go-to, and Stanley Black & Decker has become a must-avoid, in just one 24-hour period.

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