As earnings season unfolds, equity investors must focus on the bigger picture

In their new book, Radical Uncertainty, the economists John Kay and Mervyn King argue that in the midst 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. Refinitiv, a data provider, estimates Q2 earnings across the S&P 500 Index fell 40 per cent on average compared with the same period in 2019; this would represent the worst quarterly performance since the end of 2008.¹ 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 per cent between April and June.²

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 be paying 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 per cent as sales in its Medical Device segment tumbled 33 per cent.³ 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.

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.

However, while normality will resume in some sectors, the coronavirus may lead to profound and lasting changes in others. The pandemic could precipitate fundamental behavioural shifts and companies that depend on bringing customers together into close proximity indoors – such as pubs, restaurants, cinemas and concert venues – face an uncertain future. In this context, fretting over whether an operator’s revenues are down 60 per cent or 90 per cent in the recent period is misguided; the correct question to ask is whether, over the longer term, people will have less appetite to go to these places, and if so by how much.

By contrast, technology firms are going from strength to strength, benefiting from increased demand for video communications, online shopping and streaming services during the pandemic. Microsoft and Ocado are among the companies that have announced strong revenue increases over the second quarter.

While conventional recessions tend to erode value across the board, the current crisis has proved to be a massively value-creating event for some tech companies: remarkably, the tech-focused Nasdaq Composite Index had risen 15.5 per cent in the year to July 24.  By contrast, the S&P 500 was down 0.5 per cent over the same period.⁴

The rise in tech stocks looks to be a justified response to sustainable patterns of demand, with remote working and e-commerce likely to become an even bigger part of our lives in the wake of COVID-19. However, not all tech firms will be worthy of their inflated stock prices and investors must be discerning if they are to find real value.  The key question is the extent to which new patterns of behaviour become entrenched habits, and how much of the windfall of newly acquired customers can be retained.

It can be difficult to step back and focus on the bigger picture during periods of market volatility. Psychologists have proved that behavioural biases such as short-termism and loss aversion – a phenomenon that leads investors to sell assets rising in value more readily than those falling in value – are significant drivers of market pricing at times like this. But investors who can keep their cool and assess what’s truly going on behind the numbers can still find attractive opportunities.