By David Nelson, CFA
Just 3 months into 2016 and already investors have been forced to deal with a lifetime of emotions. Too often we rationalize our decisions to buy and sell based on a subjective view of the market that can’t help but be influenced by the media and our own fear and greed. There are no warranties on Wall Street so having a process and sticking to it helps sort through the noise and volatility.
Every analyst and portfolio manager has factors and or data points they examine as part of the decision making process when making a buy or sell decision. The hundreds of data points at our disposal help us frame a thesis about an individual company or stock. While the following metrics are always important I believe this earnings season they take on added significance and will confirm the rally or expose it as just another head fake.
1. Estimate revisions
There’s no question that the market this year has been challenged and in some ways the indices have been marking time waiting for the fundamentals to catch up. As pointed out in previous posts today’s S&P 500 (SPX) estimate of about $122 isn’t far off from the estimate for 2015 made about a year ago.
Estimate revision data from Reuters shows the root of the problem. While the number of estimates are declining as we approach the first Q1 reports the ratio of downward to upward revisions has consistently been negative since the end of last year. There are a lot of explanations but in the end it may not matter. Investors want some food on their plate and are looking for earnings growth. The good news is that stocks are often a discounting mechanism and perhaps the recent price performance will translate into better management guidance as the first Q1 reports start rolling in next week.
The earnings expectations game is a powerful theme that every CEO needs to master to successfully navigate the demands of Wall Street investors. The question for today; has the bar been lowered enough for management to trip over it and give us a positive surprise?
The estimate revision graph for JP Morgan (JPM) speaks to the heart of the issue. At the start of the year the estimate for the quarter about to be reported was $1.54 and today stands at $1.28 a nearly 17% cut. For some banks like Bank of America (BAC) it’s even worse as their estimate has declined 21% since the start of the year.
While the overall data is skewed to the downside investors willing to dig will find any number of companies who’ve seen their estimates revised higher. Alphabet (GOOGL)* numbers have been rising since the start of the year and got an even larger boost post their last earnings report.
Will management raise the bar and more importantly will they raise the bar on revenue. For the last year I’ve listened to a parade of CEO’s complain about the strong U.S. Dollar (DXY) and the revenue headwind it creates, particularly for large cap U.S. multinationals. While the dollar is up dramatically over the last 5 years, it’s actually down over 4% since the start of 2016 so should be less of a drag.
2. Buybacks
If management raises earnings guidance but leaves revenue unchanged then the likely explanation is financial engineering i.e. stock buybacks. With profit margins at record highs, most CEO’s have turned to the stock buyback as their savior. Remember, in the end a stock buyback does nothing to boost the earnings or revenue at the company. All it does is reduce the share count and increase earnings per share. Unfortunately, that comes at the expense of R&D and CAPEX as management sells the company’s future to make stock based compensation targets today.
One look at a performance spread chart comparing the S&P 500 Buyback index to the S&P 500 shows this is no longer a winning hand. While the chart over the last 5 years shows massive outperformance of the Buyback Index, the last 12 months tells a different story. You can see the SPDR S&P 500 Buyback ETF (SPYB) comes in well behind SPDR S&P 500 (SPY)* over the last year. (Click here for my CNBC interview on buybacks with Michelle Caruso Cabrera and Eric Chemi)
Today’s investors see the emperor has no clothes and are no longer falling for buyback mania. While I’m at risk of repeating myself, “the next leg of the bull market will not come on the backs of financial engineering.”
*At the time of this publication funds managed by David Nelson were long these securities
