What should investors think when companies can’t estimate their earnings?
Five years after the Wall Street Crash of 1929 and the beginning of the Great Depression, Benjamin Graham and David Dodd, both professors from Columbia Business School, published the book Security Analysis. This book outlined the foundation for what we now call “Value Investing” and Benjamin Graham specifically is widely hailed as the “Father of Value Investing.”
There is one observation from Graham and Dodd that has been passed down among value investors in various forms since 1934 and it is this:
"In the short run the market is a voting machine, but in the long run, it is a weighing machine.”
That one observation suggests that there are essentially two forces that move the price of stocks – human emotion and business fundamentals. In the short run, human emotion – like fear and greed – can overwhelm business fundamentals and move stock prices up and down. But in the long run, it is the earnings of a business that determine returns.
Since 1934, that observation has morphed into the simple phrase “Earnings Drive Stock Prices.” But what does that really mean? And has COVID-19 altered its meaning?
COVID-19 & Fear
It has been well documented that no previous infectious disease has impacted the stock market as much as the COVID-19 pandemic. The longestrunning bull market came to a screeching halt and the bear-market that took its place arrived faster than all other bear markets in history. Volatility spiked. Two of the 5 largest daily percentage losses in the NYSE occurred in March 2020 (with the other three occurring in 1987 and 1929). Massive unemployment. Record government stimulus. You know the rest.
But how much has COVID-19 altered the current and future earnings of companies? It’s likely true that in the early days of COVID-19, investors were trading on emotion, but there is no denying that COVID has impacted corporate earnings. Worse, what should investors do if they have no idea what kind of earnings a company might have because so many companies won’t even hazard an estimate?
During every quarterly corporate earnings season, independent research analysts create reports that provide estimates of a company’s expected earnings for future quarters and for the next year. All of these analysts’ estimates taken together are then considered “consensus” earnings estimates. Further, most publicly-traded companies also provide their own guidance on expected earnings.
Unfortunately, due to COVID-19, many companies are having difficulty providing an estimate for future earnings due to the uncertainty surrounding the impacts of COVID-19. As a result, they are simply withdrawing guidance altogether. Consider this from research firm FactSet:
• Of the 474 companies that had reported earnings for Q12020 as of May 22nd, 267 (56%) mentioned earnings guidance for the current year.
• Of those 267 companies, 172 (64%) stated that they were withdrawing or had already withdrawn previous earnings guidance for 2020.
• Nearly all 172 companies cited the uncertainty of the future impacts of COVID-19 as the reason for withdrawing earnings guidance for the full year.
What Should Investors Do?
It is of course disheartening when a company seems to say: “we have no idea how much we might earn this year because there is just too much uncertainty.” That might cause an investor to just want to walk away completely.
But remember this: public companies have to be very careful when giving earnings estimates because there are very strict securities laws governing what they can and cannot say. And just because a company is withdrawing its estimates, that doesn’t necessarily mean that everything is bad.
In fact, consider the one sector that intuitively should hold up decently during a pandemic: health care. According to FactSet, the Health Care sector had one of the highest number of companies withdrawing earnings guidance (Industrials and Consumer Discretionary were up there too).
That seems counter-intuitive, right? Well, maybe not. Again, it’s natural to assume that a company is withdrawing guidance because they just can’t estimate how bad earnings might be – but the opposite can be true too.
Bottom line: investors should always take a company’s earnings estimates with a big fat grain of salt anyway. Same is true for consensus estimates.
Maybe instead investors should heed the words of Warren Buffett, one of the more famous disciples of Graham & Dodd, when he said:
“Only buy something that you’d be perfectly happy to hold if the market shut down for 10 years.”
Yes, 10 years is a long time. But you’re investing in the stock market with a long-term perspective anyway, right?