A few weeks ago I penned my quarterly letter to clients. In the letter I noted the good earnings coming from companies reporting third quarter results. I noted, however, that I was not sure if the earnings were the result of cost cutting or sales increases, but I promised to follow up on this question. Thankfully, Standard & Poors and Bloomberg have made my job somewhat easier.

Before I get into specifics of this question, let me explain why there is a difference in the way earnings growth matters. As I noted above, there are two ways we can see a company grow their bottom line. One is through cost cutting. This, of course, could be layoffs but also productivity gains from working smarter or harder. The problem with these types of gains is they are not sustainable. That is, you can only cut so much of your workforce, and people can only work but so hard or fast. After a certain point, companies will have wrung all the gains from cost cutting that are available. The only way net income rises after that is from gains in total sales (revenues).

This brings me to the second half of this question. If companies are growing their top line – sales or revenues – even if they are keeping their costs consistent, this will lead to higher net income. This is also a much more sustainable model for growth. In fact, there have been several academic studies of this phenomenon. One of the most recent found the stock of companies that not only reported an earnings “surprise” – higher earnings than anticipated by analysts – but also a revenue or sales surprise significantly outperformed the market. In fact, companies that reported both earnings and sales that exceeded analysts’ expectations returned about 27% annually [Jegadeesh, Narasimhan and Joshua Livnat. 2006. “Post-Earnings-Announcement Drift: The Role of Revenue Surprises” Financial Analysts Journal, vol. 62, no. 2 (March/April), pp 22-34.]! Now, this is not to say that you should expect any particular company that reports higher sales and earnings than predicted to reward you with such a high return. What you can expect is that a portfolio of such stocks should outperform the broad market.

This brings us back around to the two key questions we need to ask. First, have earnings increases been a function of sales increases or cost cutting and if it’s the former, how many surprises were there? In an article on Bloomberg’s website [http://www.bloomberg.com/news/2010-10-27/third-quarter-of-10-s-p-500-sales-summary-table-.html], Standard & Poor’s, the keeper of the data for the S&P 500 Index, reports the statistics roughly through the end of October. What we see is that nearly half of the S&P 500 companies have reported third quarter results (231) so far. Of the companies that have reported, about 4 out of 5 (182) have reported higher earnings compared to the same period last year and with a 7.8% average sales gain.

More important, however, is the number of companies that are reporting positive earnings surprises. This turns out to be a positive sign, as well. It seems that 55% (128 companies) have surprised analysts by reporting better earnings. On average, earnings have only been about 0.8% higher than expected, but any growth is certainly better than no growth. If, based on the academic research, we can expect these 128 or so companies to outperform the market, this bodes well for continued growth in stock prices.

Let’s dig just a little deeper though to see what we might be able to infer about future growth prospects. When we look at just the sectors reporting higher sales, the overwhelming leader is the tech sector where hardware manufacturers (computers, for example) showed sales growth of nearly 55% over last year. This is not too surprising given the uncertainty of the economy last year and the recovery into this year. Companies are feeling a little better about things and willing to upgrade equipment again. After the tech sector, we see a few surprising things. While food and beverage companies have shown earnings growth – not surprising if consumers are pulling their horns in and hunkering down against a long, slow recovery – but we also see sale growth in some surprising areas. Other notable sectors with increasing sales include consumer durables (think ‘washers and dryers), retailing (malls) and transportation (railroads). These would tend to point to a recovery happening in the economy. However, much of these sales increases were expected as analysts’ estimates were not all that far off for most of these sectors. In fact, analysts tended to overestimate food and beverages and transportation.

When we look at the sectors that have surprised analysts the most, the two that have surprised the most (so far) have been auto sales and real estate. Auto sales is a little surprising given the government’s “Cash for Clunkers” incentive last year to buy a new car that everyone seemed to think was going to “pull forward” car sales. The thought was that the bulk of the sales under the government’s program were car sales that might have happened over the next couple of years, but those trade-ins and trade-ups were hurried to take advantage of government incentives. Real estate is another matter, of course. The general consensus is that real estate is still in the doldrums with a lot of inventory of unsold homes still on the market. Until these homes are sold and inventory reduced, real estate prices will not likely recover. Seeing higher unexpected sales in this sector bears further research. It could be that analysts were just too negative on this sector of the economy, making it easy for these firms to surprise to the upside.

The bottom line here is that we are looking at a mixed picture. There are some signs that we are slowly clawing our way out of a very deep recession. I refuse to go back to the ‘green shoots’ of last year since most of those turned out to be weeds. I will admit that things are slowly getting better but we still have a long way to go. However, much uncertainty remains. Until businesses get more clarity and take the initiative to hire more employees and increase spending on capital goods – the machines and moving parts of companies that make widgets and such – we will remain in a slow-moving funk. Over the long-term, however, America has been quite resilient. I’ll continue to believe that we will come out of this mess better, stronger and healthier but I will continue to take every advantage of the volatility that ensues to snap up good companies at great prices.