The revised estimate for first quarter 2014 GDP growth showed a 2.8 contraction (-2.8% growth), compared with an initial estimate of 0.1% growth. That revised figure represented the economy’s weakest quarterly performance in five years. GDP statistics are estimates; nobody thinks the real economy is as bad as the -2.8% number looks on its face. The job market seems to be firming up, which is inconsistent with a recessionary economy. The housing market continues to improve, albeit at a slower pace recently. Auto sales remain strong. Inflation is perking up a little, which wouldn’t happen in an economy plunging into recession.
The two biggest drags on Q1’s performance were severe weather and volatile estimates of healthcare spending. That second factor, healthcare spending, is basically just a bookkeeping problem. Economists aren’t very good at estimating recent healthcare expenditures due especially to the long delays between when healthcare is delivered and when it is finally paid for. It’s probable that Q4 healthcare expenditures were severely under-estimated. In any event, Q2 GDP should look much better than Q1, as some of the potential GDP lost to weather in Q1 will have been recaptured in Q2. Because of that pent-up demand, we expect Q2’s GDP reading to actually overstate the underlying rate of real growth.
The fact that better figures are on the way is cold comfort, however, as once again in 2014 we find ourselves making excuses for subpar economic performance. We were doing the same thing last year in the August 2013 issue of Investor Advisory Service—grumbling about an economy showing annualized Q1 growth of just 1.8%. Even the uninspiring 1.8% figure was probably an overestimate of the economy’s underlying strength, as one-third of that 1.8% came from inventory accumulation. Last year we blamed higher taxes as the likely culprit, combined with consumer skittishness due to fear of a potential federal government shutdown. We can look back at the market’s strong performance over the last twelve months—up almost 25% including dividends—and see that last year’s economic sputtering actually came with a big silver lining for stock investors, as falling long-term interest rates favored higher valuations for stocks. We’ve always argued that stocks are superior to bonds for long-term investors because they offer better appreciation potential and better protection against inflation. While investors often favor bonds because they display less volatility, it appears that bond yields have finally fallen so low that retail investors are being tempted into stocks again. Welcome back, everyone.
Big companies that pay dividends have been some of the biggest beneficiaries of the return of the yield-starved small investor. The IAS focuses on growing companies, which means we tend not to cover a lot of big, mature dividend payers. We do have a few that mostly fit that bill, however.
One of our favorites is Qualcomm (Nasdaq: QCOM), which we profiled as one of three feature companies in the August 2013 issue. Qualcomm invented the core CDMA technology behind the mass adoption of mobile phones. Every modern smartphone contains Qualcomm technology. About half of the company’s profit comes from selling microchips, modems, receivers, and other wireless solutions to original equipment manufacturers (OEMs) for use in mobile phones and other devices. The other half of profit comes from licensing Qualcomm’s considerable intellectual property to other technology companies.
We added Qualcomm to the IAS in July 2012. Although it is a universally well-respected company, Qualcomm was out of favor with investors at that time. Many questioned whether the company’s best days were behind it, as the technology standard for mobile phones was moving away from the CDMA past toward a Long-Term Evolution (LTE) future, also known as “4G”. We thought Qualcomm would continue to succeed as it had in the past. The company’s next-generation technologies include many cost and performance-leading solutions. We didn’t see any single company or competing standard out there which seemed likely to displace Qualcomm as the mobile technology leader. Qualcomm shares made some small gains initially, but the stock was a bit of a slow starter for us, underperforming the S&P 500 during its first year in the IAS. Believing that the market was starting to warm to Qualcomm’s growth prospects, we profiled the company again in August 2013. With a P/E of about 19, and a yield of about 2%, we modeled a 6 to 1 potential gain / loss.
Since that 2013 write-up, shares have done much better, outpacing the S&P 500’s strong performance by an additional 5%. Before a pull-back in late June, the outperformance was closer to 10%. We could tell two competing stories as to why this has occurred. One is simply that investors have returned to big dividend-payers. Look at the recent performance of low-growth behemoths like Microsoft and Intel as evidence. Old technology seems to be back in favor. We think Qualcomm has much better long-term prospects going forward, but all three stocks have done well over the past twelve months, and it could be the same investors driving up all these big tech stocks in the pursuit of yield.
The other story we could tell about Qualcomm’s rise is fundamental. While the company’s competitive position hasn’t changed much in our eyes during the past two years—it’s still very strong—investors have woken up to the stock as the company’s success is only now really showing up in its bottom line. Sales growth hasn’t been a problem for Qualcomm. Total sales have increased 38% since we started following the company two years ago. Earnings growth has been lumpy, however, especially on a non-GAAP basis. Ironically, more conservative GAAP accounting tells a much more exciting story in our eyes for Qualcomm. Most companies use various non-GAAP adjustments to paper over volatility in their GAAP earnings. Sometimes the adjustments are reasonable, sometimes not. Things have been working the other way at Qualcomm lately. The company’s GAAP earnings per share has grown 27% over the past two years, approximately in line with sales growth, but non-GAAP growth has been slower. As a result, the difference between the two figures has narrowed considerably. The drop from non-GAAP performance to GAAP performance is not as steep as it once was. We almost always prefer to look at GAAP figures. We don’t have a lot of patience for “if-dog-rabbit” accounting. In our eyes, growth has been consistently good at Qualcomm over the past two years.
In contrast, the market often seems to prefer the adjustment-laden non-GAAP figures. Since non-GAAP growth has been lower than GAAP growth, the market hasn’t been as impressed with the company as we have over the past two years. We can’t control the prevailing sentiment. Water finds its level. Over time, GAAP and non-GAAP performance should tend to move together. Sometimes one will be higher, sometimes the other. We still see a bright future for Qualcomm. The valuation remains reasonable. We continue to like the stock.