Earnings Outlook for Alcoa AA and Costco COST

October 6, 2009

It’s my favorite time of year—earnings season!  Now that we’ve officially closed the door on the third quarter, it’s time to look under the hood of some of Wall Street’s biggest names and see how smoothly these companies are running.

Picking a stock is a lot like picking out a new car. You have to kick the tires and really do your homework if you don’t want to buy a lemon. A good car buyer will assess prospective automobiles across a range of factors—safety, horsepower, fuel efficiency, price—before making a final decision. A car doesn’t have to be perfect across the board to be a good buy, but a failing mark in any of these categories is usually a big red flag.

Think of earnings as your chance to walk around Wall Street and kick the tires on all the stocks. Quarterly numbers such as sales growth, earnings surprises and profit margin can tell you a lot about a company.

And after the uncertainty investors have dealt with over the last 18 months, it’s more important now than ever before to know the facts underlying your investments.

Since investors are in such an earnings-focused mindset right now, this week we’re going to pit two stocks head-to-head in anticipation of their upcoming quarterly reports this week. Alcoa (AA) and Costco (COST) both report earnings on Wednesday, October 7. In today’s issue of Stock of the Week, I’ll explain to you how I expect each of these stocks to perform—and most importantly, whether either company is a good buy right now.

Earnings Are Everything

First, let me stress that the upcoming third-quarter earnings announcements we are about to witness will provide a crucial turning point for the market. Most insiders estimate that this will be the first quarter in over a year where the S&P 500 averages positive earnings across its components. It’s not hard to see why—businesses have slashed payrolls and cut costs due to the recession, and now that the economy is on the way up, they are taking the growth to the bank. What’s more, the bar is set pretty low due to easier year-over-year comparisons. Consumer sentiment, while weak, is still much better than it was during the fall of 2008 at the height of the financial crisis.

As a result, I expect an avalanche of favorable earnings reports to really light a fire under traders this fall, and we should see volume pick up as money starts to chase the strongest companies on Wall Street. That’s because earnings prove which stocks are good investments and which stocks are bad investments. If a stock can show it is growing sales and profits, investors clearly will want a piece of the action. If a company continues to lose market share and its balance sheet is in the red, traders will dump their shares and look for a better stock.

That’s why I love earnings—because the profit potential of a stock is right there in black and white.

Find Tomorrow’s Earnings Winners Today

It’s easy to see how earnings affect a stock—after a strong quarterly report, even a large-cap company can soar by 5%, 10% even 15% in one day alone. That’s because the stock has proven its worth to investors and will enjoy big buying pressure as a result.

But how do you find this elite group of companies that will attract the biggest buying pressure ahead of time? After all, you want to buy in BEFORE the surge.

The answer is quite simple: Follow the facts.

After all, earnings aren’t just calculated the day before a quarterly report. There are many indicators of a company’s success before it posts sales and profit numbers every three months. These include regular sales reports, cash flow and Wall Street estimates of the company’s future performance. I call these individual readings “fundamentals.” Taken together, a stock’s fundamentals give an accurate picture of where a stock is heading.

A stock doesn’t have to be perfect to be profitable. If a company has mediocre margins but blowout sales, it could be a good investment. Or on the other hand, if a company has plush margins and mediocre sales, it could also be worth a look. The idea is to look at all the component parts and make an educated assessment of a stock before buying in.

Let me give you a real-world example by breaking down metals giant Alcoa (AA) and warehouse discounter Costco (COST) to show you how earnings tell the story: