'What is going on here?' Equity investors must focus on bigger picture as earnings season unfolds
Look beyond quarterly figures to assess long-term value
In their new book 'Radical Uncertainty', economists John Kay and former Bank of England governor Sir Mervyn King argue that in the middle of a crisis, decision makers should take a step back and ask, "What is going on here?"
This deceptively simple question can yield useful information about the specific dynamics of the moment, as well as the longer-term implications of current trends.
It is particularly useful advice for equity investors as companies disclose their financial performance for the second quarter of the year.
After months of turmoil, the fog of war is lifting, exposing the damage caused by the lockdown-related slump in economic activity.
Data provider Refinitiv estimates Q2 earnings across the S&P 500 index fell 40% on average compared with the same period in 2019. This would represent the worst quarterly performance since the end of 2008.
'Worst quarterly results in years' push UK into earnings recession
The picture is even bleaker in Europe, where earnings among companies listed on the pan-European STOXX 600 Index are expected to have fallen as much as 60% between April and June.
Earnings reports provide a valuable snapshot of corporate performance, though some metrics are more relevant than others. When reading them, investors should also acknowledge the conditions under which they were delivered.
In the current environment, investors should pay special attention to companies' operating leverage and the state of their balance sheets, especially where there is a risk debt covenants will be triggered by a further decline in revenues, forcing firms to raise equity.
At the same time, it is important not to become too distracted by short-term data, however bad the numbers look. The key to sustainable investing is to put these figures in context and draw the correct conclusions about wider themes and trends.
So, to ask Kay and King's question, what is going on here? One quirk of the current crisis is that some good companies will have suffered a sharp drop in revenues due to lockdown measures, despite having otherwise healthy balance sheets and sustainable business models.
Considered in isolation, quarterly earnings figures are likely to create a misleading impression of these firms' prospects.
Take medical device manufacturers. At the height of the pandemic, most hospitals postponed elective procedures such as hip and knee replacements to focus on treating Covid-19 patients, hurting the revenues of the companies that make the implants.
Johnson & Johnson, for instance, has reported a decline in earnings of 35% as sales in its medical device segment tumbled 33%. That division slumped to a quarterly loss, citing the fall in elective procedures as a factor.
But this activity will no doubt resume as the crisis lifts, owing to pent-up demand from unmet medical need.
Global bargain hunt: What are the world's five cheapest stockmarkets?
On the discounted cashflow valuation model, it is largely irrelevant whether a crisis-hit company recovers its usual revenue streams within 12 months or three years as long as it gets back on its feet eventually.
Investors should be on the lookout for good companies whose share prices have suffered unduly due to panic selling on the back of poor performance over a single quarter due to a transitory event.
More on Equities
