Contrarian Earnings Season
Adam Hamilton April 13, 2001 3889 Words
EARNINGS SEASON! While merely two words, it never ceases to elicit a wide range of emotions from different participants in the chaotic US equity markets. Depending on where one stands, earnings season can be a blessing or a curse.
For the promoters, salesmen, and cheerleaders, like the financial television networks and financial newspapers, earnings season is an electrifying time where viewership or readership increases, individual stocks move dramatically, and anticipation and excitement reign supreme.
For those who fancy themselves “long-termers” and believe short-term equity movements are irrelevant, earnings season is a curious spectacle of froth and frenzy on Wall Street. The long-termers watch the display in disbelief, if they even care, and wonder, “What is the big deal? What is one quarter in the grand scheme of things?”
For professional mutual fund managers running Other People’s Money in a brutal bear market, earnings season is downright terrifying. The lion’s share of professional money runners are creatures of the herd, they pile much capital into the same relatively few mega-cap companies. If the earnings for the mega-caps are less than optimal, the majority of fund managers get hit at the same moment in time. The mega-caps tend to move with the markets in lockstep, and the returns attained by the average fund manager are largely influenced by the general market action. In bull markets and mania blow-offs, earnings season is a lot of fun for conventional professional investment managers. In bear markets, however, when bad news abounds and hope grows cold, earnings season provides many sleepless nights for the professionals graded on quarter-to-quarter short-term performance.
For contrarian speculators earnings season is a time of vast opportunity, great wonder, and good clean fun. Contrarian investors are that strange breed of black sheep who buck the herd. Contrarians are the antithesis of momentum investors. Contrarians seek to be in a market, sector, stock, commodity, or derivative before everyone else discovers the value there. The contrarians are the eccentric folks buying up straw hats in the deepest, darkest, coldest days of winter when they are almost being given away. Then, six months later, in the dog days of August, the contrarians are more than happy to sell those same once scorned straw hats to overheated vacationers for huge profits.
Contrarians move against the grain. If you find a sector touted on bubblevision that has run up dramatically in recent months and is predicted to grow exponentially by the “experts”, chances are the contrarians have already bought low when it was out of fashion and sold high in the run-up. Once a sector becomes widely known and popular, the contrarians are usually already realizing their long profits. When a contrarian sees something touted on bubblevision as “The Next Big Thing”, it is often a tempting target to short. Contrarian speculators truly live to buy when the thundering mainstream loathes a sector and sell when the mainstream can’t get enough of a sector. Contrarians are among the last remaining speculators and investors who still believe AND practice the ancient wisdom of “buy low sell high.” They are a unique breed indeed.
Earnings season provides a cornucopia bursting with opportunities for the contrarian speculator. Once a quarter, the legions upon legions of publicly traded corporations in American equity markets tell the whole world how they are doing. They open their books and reveal how much money they have earned or lost in the preceding quarter. Often their announced results move stocks dramatically. It is not uncommon to see 10%, 20%, even 30%+ moves in reporting companies’ stocks in a single day during earnings season. Extreme volatility in individual equity issues is one of the exciting hallmarks of this “report card” time for public companies.
Although it can seem cryptic at times, earnings season is really easy to understand when the fat is boiled away and the basics are laid bare. One word sums up the whole earnings season great game… expectations.
Expectations are incredibly important and permeate our entire lives, not just the equity markets. Expectation management is an important core management objective of the vast majority of industries and businesses in the world today. Expectation management is also extremely important in our day-to-day personal lives. Here is one example, and you can easily think of a gazillion more…
Imagine it’s the anniversary of the day you married the love of your life. Unfortunately, it is a normal workday in the middle of the week, and you are working that day, and both you and your spouse are really looking forward to spending some quality time together that evening. You are busy on a project, and expect that you won’t be able to make it home until 6:00 that evening. What do you tell your spouse?
You might be an eternal optimist like a typical Wall Street analyst. You call your spouse in the morning and say, “Honey, today is important so I will be home by 4:30 this afternoon.” Your spouse is very excited. Now they get more quality time to spend with you on your anniversary and all is well in the world. They are expecting you at 4:30, but you don’t show up. It turns out that you really couldn’t get away earlier because an important client called, so you don’t arrive home until 6:00. Are you in trouble? Chances are you are in the doghouse. You set high expectations, and then you failed to meet them, and your spouse is very unhappy about having to angrily wait around while you were “late”. Not a happy scenario.
Now, zip back in time to the morning again. You call your spouse and say, “Darling, I am really sorry but things are hectic and I don’t think I will be able to make it home until 7:30. The night will still be young though so we can just move our celebrations back a bit.” As the day marches on, you realize that you really will be home by 6:00. You walk in the door to your house at 6:00, and arrive as a hero to your spouse, whose expectations were exceeded. All is well and you share your best anniversary celebration ever. A great scenario!
Pondering this example, what is the fundamental difference between the first and second scenario? After all, both times you arrived home at 6:00, so nothing tangible and real actually changed. The difference, as is obvious, lies solely in the expectations. On a scale of 1-10, 10 being best, if you tell someone to expect a “1” and you actually deliver a “5”, they are ecstatic. If you have trumped up expectations, however, and tell them to expect a “10” yet you can only deliver the exact same “5”, you are in trouble.
Actual performance is usually not measured in absolute terms in the short-run, but against expectations. Exceed expectations and you are a hero, miss expectations and you are a goat. It is that simple. If you attain a good grasp of this concept intellectually, you are 90% of the way to thriving through earnings season!
With expectations in the bag, the second critical concept for the contrarian speculator planning to reap vast harvests from the chaotic earnings season is valuation.
Valuation is the single most important concept of long-term investing, and it is a toss-up between valuation and psychology as the single most important concept for a contrarian speculator shuffling short-term plays. Contrarian speculating is all about buying low and selling high, or selling high and buying low for the particularly adventurous who play the short side. How do you know if an equity is cheap or expensive? Whether it may be a good time to consider buying or selling? Valuation.
Over centuries of history of equity markets in many different nations, there is an average rate of return to which all equities on average inevitably regress over the long term. It is around 7.4%. 7.4% may not sound very impressive in today’s environment, but historically it has been the rate of return on capital that has long been proven to be near “fair valuation”. Using the old rule of 72, a return of 7.4% implies doubling one’s capital once a decade or so. That may seem like a long time, but it is a “fair” rate of return for an investor and a “fair” cost of capital for a company. A 7.4% long-term average nominal return on equities is virtually a historical constant, practically a law of finance. Study any long-term market in history and average returns over decades will always float around this number. It is time-tested and unassailable. Short-term market anomalies on returns, such as bubbles and busts, appear, but they always regress back to this “magic” number over time.
In our current strange market era, most people tend to forget that shares of stock are simply fractional ownership interests in a living, breathing business. Any stock’s value is only ultimately derived from the cashflow that the underlying business can spin off. Unfortunately, as we just begin to witness the consequences of the burst of the biggest financial bubble in world history, many still believe the bubblevision hype that stocks are divorced from reality. They ignore fundamentals, saying, “Well, this stock is off 80% from its highs last year so it must be a good value.” LOL Fantasy played an infinitely bigger role than cashflow in the NASDAQ bubble, and those fantastic “blue sky” dreams still permeate the investing atmosphere today.
If stocks are viewed like real businesses, as they should be, then the 7.4% average annual historical equity market return can be translated into the ubiquitous price earnings ratio. One divided by .074 equals 13.5. A 7.4% average rate of return, historical “fair value” over decades and centuries, translates into a P/E ratio around 13.5x. Although cash is king and cash returned on an investment is the ultimate measure of success, earnings are an acceptable proxy for cash over the long run. Over the life of a company, after all the short-term accounting fictions work their way through the books and offset each other, cashflow and accounting earnings converge. Much historical research by market legends such as Graham and Dodd suggests that P/E ratios, although largely still ridiculed today, can be one of the best tools to quickly distill the valuation of a complex business into a single easily comparable number.
P/E ratios are a critical tool for the contrarian speculator attempting to milk earnings season for very large profits.
With a well-established P/E ratio of 13.5x earnings that has been considered fair value over decades and centuries of equity trading, we can leverage that historical reality to assign equities into three basic groups. We can arbitrarily divide stocks based on P/E ratios… those over 15x earnings, those between 12x-15x earnings, and those under 12x earnings.
Companies trading over 15x earnings are being assigned a premium value by the market. Maybe they are small, rapidly growing companies for which many have very high hopes. Maybe they are large, mature companies that have performed well in the past so the market thinks they are worth more than other companies by virtue of their past performance record. Generally, if an equity is sporting a P/E of over 15x, the market has very high expectations for the company. From a contrarian speculation standpoint, if a company has a P/E over 15x, then it is a candidate for investigation. Why is it worth so much? Why is its price higher than normal companies? We call this group the “market darlings”. They are loved and wanted, and their prices have been bid to high levels. They are overvalued from a pure fundamental perspective.
Companies trading between 12x-15x earnings are the ones considered “fair-valued” in light of historical equity market precedent. Companies with P/Es in this range are usually not very interesting for the contrarian speculator. They seem to be pretty much properly priced, and the odds of volatility that can be traded for speculative profits are much smaller than the companies valued on the P/E extremes.
Companies trading for under 12x earnings are generally unloved and unwanted by the market. They are the rejects, often in sectors not considered sexy, and hence their prices are low. They have been sold down by the markets, so their P/Es are low and their earnings and cashflow are high for their price. While conventional market participants usually wouldn’t touch boring spurned companies like these, they are a contrarian’s dream. Investing legends like Warren Buffet made their fortunes by buying companies that were out of favor, like straw hats in the winter, and selling them at huge profits when the rest of the market realized the valuation anomaly. Any company trading with a low P/E warrants investigation. We call this group the “downtrodden”. Expectations are low for the downtrodden and they trade at a discount to the rest of the market. They are undervalued from a pure fundamental perspective.
One of the most important functions of a free market is to eliminate valuation anomalies. Through their own self-interest to individually profit, millions of market participants ultimately sell off stocks trading at a premium and bid up stocks trading at a discount. The free market does not like to see the market darlings offering trivially small returns (remember long-term returns are the inverse of the P/E ratio) so it ultimately sells off the darlings to seek higher returns. This ultimately pushes the market darlings’ prices back down to fundamentally sound levels. At the same time, the market lusts after the anomalously high returns provided by the downtrodden stocks over time. They are bought until their price rises to bring them back into the fair value universe.
Through the convergence of expectations, historical rate of return norms, valuations, and psychology, contrarian speculators can make a killing through earnings season.
With every stock ultimately regressing to a normal valuation based on its cashflow over the long run, earnings season offers a temporary chance to short-circuit the normally slow revaluation process. Companies’ stock prices can move dramatically as earnings are announced, as actual quarterly earnings results miss, meet, or exceed expectations.
The behavior of the downtrodden versus the market darlings when they announce earnings surprises are typically quite different.
When the downtrodden low valuation stocks MISS expectations, usually nothing significant happens. After all, they are the unwanted downtrodden stocks, nobody really cares about them at the moment, and their valuations are already low. When the downtrodden EXCEED expectations, however, fireworks can fly. A big positive earnings surprise (exceeding expectations) on a low valuation stock can instantly spark wide interest in the stock and place it on the radars of many big market players. As buy orders flood in due to the exceeded expectations of the downtrodden stock, the price can rise dramatically. Contrarians seek to identify candidates for this behavior, pre-position capital in the downtrodden stock in advance, and ride the wave as earnings season lifts the stock into higher orbits. Buy low sell high.
On the other hand, when market darling high valuation stocks EXCEED expectations, there are usually no price explosions. Market darlings are high P/E stocks that are priced to perfection. They command a huge premium over the market, their fundamental returns are very low, and market participants always have stellar expectations for their operating results. If they exceed, usually the market just shrugs, thinks “I knew they were good”, but generally massive new buying doesn’t flow into a market darling when it exceeds. It is already overpriced and the big players already own it.
BUT, if a market darling MISSES expectations, all hell can break loose in the stock. The market darlings have amazingly high P/Es because the market expects much of them. When they fail to deliver, the market is upset and many players immediately sell them hard, driving the price down, sometimes dramatically. For the contrarian speculator, the mission is to identify these premium stocks before earnings season and then commit capital to the short side. The speculator bets that the company will not be able to exceed expectations in the coming earnings season so the stock will drop as it misses. The contrarian speculator can borrow the stock and sell it now at a high price, and buy it back later at a low price to return to its owner, with the contrarian pocketing the difference as a profit… a short sale. Sell high buy low.
Enter our currently underway earnings season in the United States.
Although hopes are high on bubblevision for a great quarter (as they were in the previous three quarters, each of which disappointed and witnessed increasingly massive amounts of earnings misses), odds are Q1 2001 won’t be that great, and next quarter will probably be even worse. Many ironclad economic indicators suggest we are already in or plunging into a recession, a dizzying amount of capital has evaporated in the NASDAQ debacle (hence less available to rush into stocks to bid them up), US corporations are drowning in debt, the US consumer is also heavily indebted AND has negative savings, the dollar is probably topping, etc, etc. There are a myriad of fundamental reasons that would suggest that the general business environment will NOT get better from here over the intermediate term. The same folks happily announcing the markets have bottomed (for the umpteenth time since last March) were the very ones calling for NASDAQ 6000 and Dow 15000 early last year. They are simply trying to drum up business for their Wall Street firms, and are ALWAYS optimistic.
Today’s leading companies’ valuations buttress the idea that downside risk is MUCH greater than upside potential for our currently underway earnings season. Using the foundational historical concepts of valuation, let’s take a look at the ten biggest companies in the United States in terms of market capitalization. All data is from the end of Q1. Are there any fundamental bargains that are likely to rally dramatically on positive earnings surprises?
Incredibly, ALL 10 of the largest US companies, which collectively make up 23% of the total value of the huge S&P 500 index, have an average P/E of 32.3, two to three times as high as historical norms. Two of the companies have valuations far into the ludicrous range, and are shown above with red P/E ratios. ANY mature company trading at over 50x earnings is an accident waiting to happen, and there is no rational justification for such valuations. In light of our discussion thus far, would you want to be long in any of these companies coming into this earnings season?
Ominously, if we look at the NEXT 10 biggest companies in the US, the situation doesn’t look much better. These and the first 10 companies collectively make up 34.9% of the total value of the 500 stock S&P 500. That is mind-boggling in itself and adds support to the argument that a dangerous bubble-type valuation anomaly STILL exists in the best and biggest companies in America. Here are the next 10 companies…
While a couple of these top 20 US companies show a reasonable valuation, most are still OVERvalued in terms of the amount of money they can earn and the cashflow they can spin off. The second 10 companies have an average P/E of 26.2x, still VERY high by historical standards. If you continue going down the list of the S&P 500 by market capitalization, the next 30 companies don’t look much better. Overall, the top 50 companies, mostly market darlings in terms of valuation, make up 54.6% of the TOTAL value of the S&P 500. Incredible! 55% of the equity capital in the flagship S&P 500 represents only 10% of the companies in the index!
Looking at these mega-cap companies, most of which are also in the important Dow Jones Industrial Average and/or the NASDAQ 100 index, it is hard to make the case that this quarter will see these market darlings have excellent “positive surprise” earnings announcements. Odds are, with a slowing economy and rapidly unfolding bear market, many of these lumbering behemoths will miss estimates and slide to the downside as they are sold off. The current earnings season, whether viewed fundamentally or technically, appears to be a dream for those willing to bet against the massively overvalued mega-cap companies.
And how does a contrarian speculator profit from the falls of the mighty?
The adrenally challenged can simply sell candidate stocks short. We tend to shy away from naked short sales, however, because they bear the ugly risk of unlimited loss. For instance, if you short a stock at $40 and it jumps to $120, you lose many times your original capital and your loss continues to grow as long as the stock rallies. Only sophisticated and experienced market professionals should even consider the naked shorting of equities.
We prefer to play the short side with “put” options. A put option is the right to sell a stock at a certain price for a certain period of time in the future. Put options also have fantastic leverage and can yield monstrous returns for the prudent contrarian speculator in a bear market.
For instance, imagine there was a stock trading at $50, which you thought would drop during earnings season. You could buy a $40 put option on the stock, say for $1. The option gives you the right, but not the obligation, to sell the stock at $40 no matter what the market price until the option expires a few months later. If the stock dropped to $35 before the option expired, your $1 put is now worth at least $5, as it gives you the right to get $40 for a $35 stock. In order to shoot for stupendous returns like this 400%+ short-term example, you bear the risk of a 100% loss of your risk capital (what you paid for an option) if the option expires worthless. Fortunately, when you buy an option you KNOW, worst case, how much you can lose, unlike a naked short sale.
In our private subscription intelligence briefing, Zeal Intelligence, we outline our various favorite specific high-risk option plays each month, all based on the principles outlined in this essay. Betting against the mega-cap market darlings has proven very profitable so far in 2001, and we expect it will continue to be until valuations drop from current extremes among the market darlings. This kind of high-risk high-reward speculation is not for everyone, but those with the necessary risk tolerance and non-essential risk capital available to speculate can make fantastic short-term profits. We also search for the best of the downtrodden low valuation stocks to buy outright or buy call options on (betting the price will go up), which we also detail in Zeal Intelligence. As the American bubble is still in the process of bursting, however, valuations remain extreme and it is still more profitable to bet against market darlings than to find the downtrodden to ride up at this moment in history.
Contrarian speculation is tremendously exciting, very rational, and the potential profits are huge while the risk of loss is minimized. In the current environment, where the bulls are yet again optimistically predicting a reasonably decent earnings season, we see a king’s banquet of potential and are salivating at the opportunities.
Everyone rejoice, for the contrarian earnings season is at hand!
Adam Hamilton, CPA April 13, 2001 Subscribe at www.zealllc.com/subscribe.htm