Wall Street Is Cautious on These 2 First Half Winners

Key Points

• After dropping 19% in 2022, the Russell 1000 Index is up 17% year-to-date with 63% of its constituents in the green.
• American Airlines climbed 42% in the first half of 2023 and turned a small profit in the first quarter. 
• However, American’s bloated debt balance is keeping analysts from coming on board.
• DaVita Inc. rose 35% in the first half, but its profitability is trending in the wrong direction.
• Unlike many first half winners, there’s not a single Buy rating to be found on DaVita.

Lately, it seems like the only thing that can stop the U.S. equity markets is a holiday early close. Heading into the 4th of July celebration, major stock indices are enjoying a festive 2023 thanks to 1) waning expectations of a long anticipated recession and 2) retreating inflation.  

In contrast to earlier in the year, good economic news is actually good news for stocks these days. A very mild uptick in the latest personal consumption expenditure (PCE) reading is being cheered by investors because it suggests that the Fed will soften its hawkish interest rate stance. It could also mean that consumers will be spending more and corporate America will be banking higher profits in the months ahead.

As a result, domestic equities are flipping the script from a year ago. Take the Russell 1000 Index, a widely tracked benchmark that covers approximately 93% of the U.S. market. After dropping 19% in 2022, it’s up 17% year-to-date.  

What’s more encouraging is this year’s breadth, i.e. the number of stocks participating in a rally (or downturn). This is an important gauge of market health because it strips out the outsized impact of heavily weighted mega caps. While Nvidia, Meta Platforms and Tesla are certainly pulling their weight, roughly 63% of Russell 1000 constituents are in the green. Compare this to last year’s 25% market breadth, which, well, stunk.

This brings us to the (Russell) $1,000 question: do the biggest first-half winners have more in the tank? Fourteen stocks have already doubled, including the aforementioned mega caps, Spotify and Palantir. Another 165 are up at least 30%. 

Taking this second tier of Russell 1000 winners, Wall Street is still bullish on most — but starting to pump the brakes on others. The caution flag is being waved on these two first-half outperformers. 

Has American Airlines Stock Flown Too Far?

American Airlines Group Inc. NASDAQ: AAL climbed 42% in the first half of 2023. And while Big Four peers United Airlines and Delta Air Lines posted similar returns, analysts are particularly skeptical about American.  

Last week, Bank of America issued a Sell rating on the nation’s second-largest airline (by capacity), becoming the second firm to do so this summer. American is benefiting from strong leisure travel demand and rebounding corporate travel. Unfortunately, newly negotiated pilot salaries and wages, along with elevated fuel costs are limiting the impact of higher volumes and ticket prices. 

To American’s credit, it was the only Big Four airline to turn a small profit in the first quarter, its first of the post-pandemic era. Some 48.2 million passengers generated record revenue of $12.1 billion and a $10 million profit. However, the company’s bloated debt balance is keeping analysts from coming on board. 

Through the end of the Q1, debt accounted for 116% of American’s capital structure. This was the highest figure among large cap passenger airlines — and miles away from Southwest Airlines (44%), which has long been considered the group’s fundamental leader. Although American is aiming to reduce its debt burden to at least $44 billion by year end, this may not be enough to sway the skeptics. 

This is a good example of why thorough fundamental analysis looks beyond the bottom line to leverage and other key parts of financial health. With a consensus Neutral rating and $18.00 price target, American could be in a second half holding pattern.

Are DaVita Shares Fully Valued? 

Dialysis services provider DaVita Inc. NYSE: DVA rose 35% in the first half on the heels of back-to-back earnings beats. The company has benefited from increasing U.S. dialysis treatments and international growth as health care settings continue to normalize post-Covid. The problem is, profitability is trending in the wrong direction.

Despite the significant Q1 beat, DaVita’s earnings were down 2% year-over-year. This marked the fifth consecutive period of lower profits. Operating margins have been contracting due to a mix of rising expenses, most notably higher labor costs. A struggle to staff its kidney dialysis centers may be forcing the company to pay more to attract qualified candidates. Combined with a 12.5% jump in administrative expenses, this caused Q1 operating profits to shrink 4.2%. 

The profit issue may only worsen. Analysts are forecasting a 26% drop in earnings when the company reports second quarter results next month. The full-year consensus EPS estimate equates to a 15x P/E ratio. Since this is in-line with the five-year historical average P/E, Wall Street thinks the stock is appropriately valued. Unlike many first half winners, there’s not a single Buy rating to be found on DaVita.