Strategies for Earnings Season

The earnings season will kick off on Oct. 13 with JPMorgan Chase & Co. (JPM, Financial) reporting third-quarter results. Banks will dominate the first week of the season as usual, and many investors are looking forward to these numbers as it will help them gauge how well these institutions are surviving the ultra-low interest rate environment.

The consensus estimate is for the S&P 500 Index to report a decline in earnings of 20.5% in comparison to the prior-year quarter. If this projection by Wall Street analysts turns out to be accurate, the three months ended Sept. 30 will go down in the history books as the second-worst quarter for the U.S. economy behind the second quarter of 2009, when earnings declined by a staggering 26.9%. While this paints a pessimistic picture of what to expect in the coming weeks, there are a few silver linings among the dark clouds.

The financials sector is one to avoid

Net interest margins play a critical role in determining the profitability of a bank as it captures the difference between the interest income generated by fianancial institutions and the amount of interest paid out to their lenders. The Federal Open Market Committee delivered an emergency rate cut in March that saw policy rates tumble to historic lows. This is beginning to weigh on the banking sector, which is evident from the below chart.

In addition to the decline in rates, the billions of dollars assigned as loan loss provisions by leading banks have led to a significant decline in the profitability of this sector. Considering these developments, it doesn't come as a surprise that the market performance of the financials sector is better only to that of the energy sector, which has been beaten down by low oil prices.

Source: Fidelity.

For banking stocks to stage a spectacular recovery, one of the below should happen.

1. A decision by the Fed to hike rates.
2. Robust loan portfolio growth resulting from a surge in business activities.
3. A reversal of loan loss provisions.

None of these outcomes, however, seems possible within the next 12 months, and Fed Chair Jerome Powell wrote in an update earlier last month that rates could remain at the current levels through the end of 2022. Even though the financial services sector is the cheapest from a Shiller price-earnings ratio perspective, it might take a considerable amount of time for these stocks to converge with their intrinsic value due to the lack of a catalyst.

Source: GuruFocus.

Both value and growth investors should ideally look for opportunities in other business sectors until there is more clarity regarding the outlook for this troubled industry. On the contrary, an investor with an investment time horizon extending to at least a decade might want to strategically invest in a big bank, but the liquidity profile and the business segments of the entity should be closely monitored to avoid betting on value traps. In a research report prepared in late August, S&P Global Ratings analyst Brendan Browne wrote:

"While the pace of provisioning may slow, we believe U.S. banks in aggregate are far from done with provisioning for pandemic-related losses. The allowance levels of banks at the end of the second quarter may indicate that they are more sanguine in their loss expectations than we are, and performance will be highly sensitive to how those expectations evolve. The performance will also vary significantly from bank to bank, depending not only on the quality of their underwriting and loan losses but also on the sufficiency of their second-quarter allowances and on their ability to absorb losses through pre-provision net revenue (PPNR)."

Applying a valuation discount to account for the significant uncertainty for this sector seems to be the right path forward.

Growth investors might find opportunities in the tech sector

Many tech companies have weathered the economic recession better than their counterparts representing other industries, which has been one of the unique characteristics of this downturn. Financial results that would be released in the next few weeks will likely support the continued dominance of this sector in the stock market. Companies such as Amazon.com Inc. (AMZN, Financial), Apple Inc. (AAPL, Financial), Facebook Inc. (FB, Financial) and Netflix Inc. (NFLX, Financial) are expected to report promising numbers. In case the share prices of one of these companies experiences a pullback following the release of earnings, growth investors might want to bank on the opportunity as all these companies are likely to deliver strong numbers over the next couple of years as the macroeconomic environment is favorable for these tech giants.

In the absence of a pullback, however, investing in these companies might only be suitable for growth investors with a high-risk appetite as the valuation multiples have already stretched much higher than historical means.

Source: FactSet.

Another strategy that might prove to be lucrative is to look beyond the big names for small-cap tech companies with sound balance sheets.

Contrarian strategies

An effective yet unpopular investment strategy is to identify the companies that would be punished by investors once earnings are out, and then to tactically invest in the equity of such companies as long as the setback in earnings can reliably be classified as a temporary development. While this carries a higher risk than other traditional techniques, an investor with deep insights into a sector would be able to realize handsome returns by picking out-of-favor stocks using this strategy. Airlines and cruise operators are likely to present these types of opportunities for prudent investors this earnings season. While both these sectors are going through their most challenging period in recent history, companies that survive this rough patch have a chance to grow earnings for many years to come.

The key to successfully using contrarian methods to pick stocks over the next few weeks is to pay close attention to the ability of companies representing battered and beaten sectors to survive this downturn. In other words, these companies should not be expected to generate any positive earnings until the economy recovers fully.

Takeaway

Corporate earnings tend to lead to volatile stock prices more often than not. Even though the short-term market value of a portfolio could come under pressure as a result, these unanticipated moves could present attractive opportunities to investors who carefully follow the new developments in an industry or a company. Below is a list of company earnings to look out for this season.

Disclosure: I own shares of Facebook and Starbucks. For investors, it would be imperative to acknowledge that these are difficult times for most businesses in the country and across the border. It's important to remain focused on what the future holds for the company as earnings in the next few years will drive stock prices up or down, not what the company is already going through as this has already been factored into the market price.

Read more here:

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• A Deep Dive Into Buffett's Latest Tech Investment

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