Earnings season is always an exciting time for stocks since stocks typically go up during earnings season.
Fortunes can be made and lost on a good or bad earnings report. And it’s not uncommon to see stocks move 10%, 20%, 30% or more in one day.
So far, this earnings is off to a solid start.
And with Q3 GDP numbers showing an unprecedented 33.1% growth rate, it’s no wonder we’re seeing so many companies hit it out of the park.
But that’s not true for all companies. Especially given the uncertainty the virus has brought.
There have already been, and will continue to be, distinct winners and losers. We’re also seeing that play out as new industries grab the spotlight, while others fall out of the limelight. So you have to know where to look.
The growth picture emerging from the ongoing Q3 earnings season is reassuring. While earnings remain below the year-earlier level, they represent a significant improvement over what we saw in the preceding quarter.
Even more significant than the growth issue is the surprisingly strong rebound we are seeing on the horizon, with estimates for the current period (2020 Q4) and beyond starting to go up in a meaningful and sustainable manner.
It is this improving earnings outlook that is more than making up for the weak numbers in the rearview mirror. And we all know that Mr. Market cares more about what’s ahead than what it left behind.
Let’s dive into the numbers right way.
As of Monday, November 2nd, we have seen 2020 Q3 results from 331 S&P 500 companies or 66.2% of the index’s total membership. Please note that these 66.2% of index members account for 75.9% of the index’s total market capitalization. In other words, for all practical purposes, the bulk of the Q3 reporting cycle is now behind us.
Total earnings for these 331 companies are down -8% on -3.4% lower revenues, with 86.7% beating the Consensus EPS estimates and 76.7% coming out with positive revenue surprises. The proportion of these companies beating both EPS and revenue estimates is 68.6%. Quite a positive.
We know that Q2 was effectively ground-zero for the pandemic-driven economic downturn that produced an all-time record decline in the nation’s GDP (-31.4%). We also know now that the GDP rebound in Q3 was also of a record nature, with the economy growing by +33.1%.
We can see the effects of these GDP swings in the earnings data, with Q3 earnings and revenue growth representing a significant improvement over the preceding period.
The market’s impressive gains from the March 23 lows reflected the expectation that the full brunt of the pandemic will be concentrated in Q2, with the picture starting to improve from Q3 onwards. Driving this expectation was the enormous fiscal and monetary measures put in place in the wake of the pandemic.
This expectation of ‘improvement in Q3 and beyond’ didn’t mean that we will go back to the pre-Covid levels in economic growth and corporate profitability, but rather that 2020 Q3 will be better than 2020 Q2, 2020 Q4 will be better that 2020 Q3, and so on.
We are seeing this in actual Q3 earnings results already. You will also see a little later in this write-up how estimates for the coming quarters have been evolving, which should give you greater confidence in the fundamental underpinnings of the market rally from the March lows.
As you all know, markets look ahead; and the view ahead is positive and favorable. This doesn’t mean that many folks in the country (and the world) aren’t in a lot of pain today, but rather that the pain will be a lot less going forward than is the case today or yesterday.
Putting It All Together
You can see that corporate margins are on track to fall sharply this year, erasing many years of gains.
The expectation is that we get out of this hole over time, with significant margin gains next year, followed by margins exceeding the prior peak of 11.9% in 2018 following the tax-cut legislation. It is these margin expansion expectations coupled with projections of revenue growth that are expected to drive earnings growth next year and beyond.
How Reasonable Are these Revenue Growth & Margin Expansion Expectations?
Revenue growth is a function of global economic growth, which has fallen victim to the Covid-19 pandemic. Unlike many other regions of the world, the outlook for the U.S. economy remains very good, particularly since it entered the downturn in a very strong shape. Also, the extraordinary fiscal and monetary support effectively guarantees that the bounce back will be sharp and strong. That said, a lot will depend on the level of fiscal support in the coming quarters to complement the continued Fed assistance that still remains firmly in place.
The economic picture is a lot less certain beyond the U.S. China may have been able to handle the pandemic relatively painlessly, notwithstanding questions about the country’s data integrity, but the country’s economy was in a weaker shape ahead of the outbreak and will likely find it hard to get back into shape smoothly. Other key emerging markets like India and Brazil are in even worst economic shape.
The outlook for Europe, Japan, South Korea and other developed markets is also on the weaker side, with a number of European countries reimposing lockdowns to slow the virus’ spread.
A lot is riding on the pandemic’s trajectory and developments on the therapeutics and vaccine fronts. While infection rates still remain elevated in the U.S. and a number of other countries are starting to see a resurgence as well, it is reasonable to expect that all of us have ‘learnt’ to live with this pathogen for now, obviating the need for putting the economy back in cold storage, as was the case in the Spring.
As we showed earlier, estimates have started going up already. But for the trend to continue and accelerate, we need tangible progress on the therapeutic and vaccine fronts.
The investment implication of this earnings outlook is that we look past the coming 6 to 9 months for most companies as we evaluate their earnings fundamentals, as the growth outlook turns positive in the first quarter next year. Even this year, not all companies will see their profitability decline.
You significantly increase your odds of picking winning stocks if you lean towards companies that are enjoying positive estimate revisions. You can find these stocks in a variety of ways, if we can help, please let us know.