Investors look forward to the earnings of listed companies to determine whether corporate executives are delivering the promised goods. The share price of a company, of course, typically follows the earnings. When this happens, markets become more volatile, and prudent investors will generate very attractive returns.
A company’s long-term prospects cannot be determined by just a single quarter. Regardless, investors go into a state of euphoria when a company beats earnings estimates and punish companies that miss their guidance like there’s no tomorrow. This earnings season, in my opinion, will go down in the history books as one of the most volatile periods experienced by investors in recent memory.
In an interview with The Wall Street Journal, Nuveen chief equity strategist Bob Doll said, “There is more uncertainty for this quarter than almost any quarter I remember. My guess is somewhere between a half and three-quarters of analysts have yet to take a knife to their earnings estimates because they don’t know what knife to take and how deep to cut.”
There are three reasons for this expectation:
- The economic impact of the global lockdown will come to light, along with the financial performance of U.S. companies in the first quarter of 2020. The negative impact could turn out to be much worse than the market is factoring in.
- In the upcoming conference calls with analysts, management of companies might paint a negative outlook for the remainder of the year as well, driven by the uncertainty surrounding the timeline as to when business activities will return to normalcy.
- Corporate executives might confirm that they have no clue as to what will happen in the coming weeks or months.
All these developments, collectively, will lead to a spike in volatility. Investors will thus gain chances to convert this volatility into opportunity.
The expectations are grim
According to data from FactSet, the estimated earnings growth rate for the first quarter of 2020 was 4.3% in December last year. However, many companies have revised their expectations to reflect the lost business as a result of consumers staying indoors. With these adjustments, the current consensus estimate is for earnings to decline by 10%. The energy sector will report the weakest numbers, as the industry is being hit hard by the slowdown in global business activities and the steep decline in oil prices.
Source: FactSet
The consumer discretionary sector, on the other hand, is expected to have taken a hit in the first quarter as a result of a dent in personal disposable income in the United States. Historically, recessions have resulted in a massive drop in consumer spending, which is likely to repeat in this instance as well. This naturally leads to lower earnings for companies across the board. As exhibited in the below chart, this happened during the dotcom bubble and the financial crisis.
Source: GuruFocus
On top of the disappointing data expected for the first quarter, investors are beginning to realize that second-quarter data could likely be worse. AssetMark chief economist told MarketWatch:
“I think we are in for a very rough time in the markets for the next couple of months. We are just now starting to get hard data. But it’s for March. What we are living through in April is much worse.”
However, there is no reason to lose hope. Since both the last economic downturns, S&P 500 earnings per share have recovered swiftly and grown well above the pre-recession peaks. This might happen as early as the next year. In a report published on April 15, the International Monetary Fund projected the global economy to grow by 5.8% in 2021, which, if achieved, would be the highest annual growth reported for the last three decades. Billion-dollar stimulus packages introduced by many governments around the world, including the United States and India, will be at the center of this recovery. Central Banks are also injecting much-needed liquidity.
Two gurus on volatility
Advice from Warren Buffett (Trades, Portfolio) and Charlie Munger (Trades, Portfolio) can be used to determine whether an uptick in volatility is a worrying sign for investors. Momentarily, the value of a portfolio will decline due to adverse market fluctuations. However, it’s important to distinguish between permanent and temporary developments. Disappointing financial performance will not be a feature of capital markets for a prolonged time.
Many investors equate volatility to risk, but Munger begs to differ. The guru famously said, “Using volatility as a measure of risk is nuts. Risk to us is the risk of permanent loss of capital or the risk of inadequate return.”
Stocks can move in either direction as a result of short-term developments such as an earnings miss in a single quarter or a decline in demand for a company’s products or services. This is exactly what will happen in the next couple of weeks.
Whereas Munger does not agree with the common notion of using volatility to measure risk, Buffett believes an increased level of stock price fluctuations is an opportunity for prudent investors. In the annual shareholder letter in 2013, the guru wrote:
“It should be an enormous advantage for investors in stocks to have those wildly fluctuating valuations placed on their holdings – and for some investors, it is. After all, if a moody fellow with a farm bordering my property yelled out a price every day to me at which he would either buy my farm or sell me his – and those prices varied widely over short periods of time depending on his mental state – how in the world could I be other than benefited by his erratic behavior? If his daily shout-out was ridiculously low, and I had some spare cash, I would buy his farm. If the number he yelled was absurdly high, I could either sell to him or just go farming.”
The wise thing for investors to do is to look for bargains in this market. However, picking the winning companies could turn out to be tricky as a result of the increasing number of value traps (i.e. companies that looks cheap as a result of a significant decline in the share price, but for which the lower price is a true reflection of reality). Not every drop in share price is an opportunity for investors. For instance, Luckin Coffee Inc. (LK, Financial) shares declined by a staggering 80% on April 2 with the revelation of an accounting fraud. Avoiding companies that could, for example, go bankrupt or be hit with crippling lawsuits is critical to the long-term success of an investor.
Takeaway: don’t be fooled by the earnings misses
This earnings season, many companies will report disappointing numbers. Under normal circumstances, this would have been a reason to worry. However, as the United States is on the verge of entering a recession, things are far from being normal. Therefore, companies of all scales and sizes will find it difficult to grow. Prudent investors should look to pounce on every opportunity that comes along when a great business is trading at attractive valuation multiples.
Disclosure: I do not own any shares mentioned in this article.
Read more here:
- Ray Dalio Defends His 'Cash Is Trash' Stance
- Investing Lessons From the Saudis
- Why Lazard Asset Management Is an Attractive Contrarian Play
Not a Premium Member of GuruFocus? Sign up for a free 7-day trial here.
