Q2 earnings season is now past the halfway mark. So far 63% of the market has reported. FactSet reported the EPS beat rate rose to 84% from 81% the previous week. The sales beat rate was fell to 69% from 71% the previous week. Both the EPS and sales beat rates are ahead of their 5-year averages.
The bottom-up consensus forward 12-month estimate rose 1.03% last week after a strong 1.05% the previous week The market is trading at a forward P/E of 22.0, which is well ahead of historical norms.
Strong positive revisions
Wall Street analysts have been increasing upbeat on the outlook of individual companies. Though the weekly changes in quarterly EPS estimates can be noisy, analysts have upgraded quarterly earnings estimates across the board, except for Q4 2020 earnings. Q2 2020 revisions were especially strong.
Company earnings guidance offered a “good news, bad news” message. The good news is guidance has been extremely positive, compared to the historical experience of negative earnings guidance has swamped positive ones. The bad news is over half of the companies have withdrawn guidance, citing pandemic related uncertainty. Deprived of guidance, many analysts are flying blind, which creates greater uncertainty in EPS estimates.
From the ground up
Courtesy of The Transcript, which monitors the earnings calls, the main feature last week was Big Tech strength.
There were a lot of major data points about the economy last week but the biggest news of all seemed to be just how well tech companies did despite the massive economic dislocation. In a quarter where GDP fell at a 33% annualized rate, Apple managed to grow revenue by 11%! Stimulus probably played some role in tech companies’ strong performance, but beyond the stimulus is the fact that COVID has pushed everyone to spend even more time at home and on the internet. The behavioral shifts appear to be long-lasting too. 20 years after the dot com bubble, the internet is still not done reshaping society.
Here is a brief summary of the macro outlook:
- The current economic downturn is the most severe in our lifetime (Federal Reserve, BLS)
- Earnings reports are showing that many companies are under intense pressure (General Electric, Honeywell)
- But tech and payments companies are booming (Apple, Amazon, Shopify, Paypal)
- And housing is booming too (Redfin, Boston Properties, Freddie Mac’s)
- The economy has continued to improve in July (Mastercard, McDonald’s, Starbucks, Redfin)
- Thank you government stimulus (Apple, Facebook Snap-On, Redfin, United Parcel Service, On Deck Capital)
- However, the economy is still in a deep, deep hole (CBOE, Boston Properties)
- And COVID could continue to be with us for a while (Boston Properties)
The valuation debate
One nagging issue with the equity rebound off the March lows is valuation. The market is trading at a forward P/E of 22.0, which is well ahead of the 5-year average of 17.0 and 10-year average of 15.3. There has been much discussion whether these historically high valuations are justified.
One way of thinking about the market is to separate the large cap FANG+ names from the rest of the market. Assuming that 2020 earnings are a disaster that can be ignored and investors should consider 2021 earnings for a more normalized view of P/E multiples, the top 5 stocks in the index trade at a FY2 P/E of 31, compared to 18 for the rest of the index. We can make a couple of observations from this analysis.
- Top 5 stock FY2 P/E ratios are not high compared to the dot-com era. There is a difference between the 1990’s NASDAQ bubble and today. The dot-com bubble was dominated by companies with little or no profitability, which drove up P/E ratios, while today’s FANG+ stocks are profitable with competitive moats.
- The FY2 P/E of the bottom 495 is still quite elevated by historical standards.
One signal of an overvalued market is excessive equity financings. If stocks are expensive, then companies prefer financing with cheap equity over expensive debt. That was one characteristic of the dot-com era, whose financing landscape was flooded with IPOs that skyrocketed on the first day of trading. FactSet reported that IPO activity is not excessively high by historical standards.
However, the froth in this market has turned from IPO to the SPAC, or “Special Purpose Acquisition Company”. The Economist explained the SPAC this way:
An empty vessel can accommodate all manner of dreams. This trait helps explain the growing allure of the “special purpose acquisition company” (SPAC), a shell company listed on the stock exchange with a view to merging it with a real business. Ventures such as Virgin Galactic, in space tourism, and Nikola, in electric vehicles, have become listed companies by this route. Silicon Valley’s dream factory spies a way to sidestep the trials of an initial public offering (IPO). Bill Ackman, a shrewd hedge-fund manager, has just raised a $4bn mega-SPAC. He is looking for a unicorn to make a home in his empty store.
The view in Silicon Valley is that an IPO is a rotten process. There is typically a fixed fee, of up to 7% of the sum raised. And the value of the company is lowballed, say tech types, to allow for a satisfying first-day “pop” in the share price. Yet cost is not the only bugbear—and, perhaps, not even the main one. What entrepreneurs and their venture-capital backers hate about the IPO is the loss of control. They are used to being big shots in Silicon Valley. They do not like deferring to Wall Street types at all.
In effect, the SPAC is an IPO hack. It’s a way to get around the fees of the IPO.
Enter the SPAC, which is a sort of pre-cooked IPO. A shell company is set up by a sponsor. The SPAC is listed on the stock exchange via an IPO. The sponsor then finds a private business for the SPAC to acquire with the proceeds. Typically this will be a late-stage (ie, fairly mature) private company, whose owners and venture-capital backers are looking to cash out. The private company merges with the SPAC, following a shareholder vote. It is then a public company.
The usual fee for the sponsor is 20% of the equity, which is a way of compensating him and the SPAC management team. The concept of the SPAC is not new. At the height of the South Sea Bubble, one company raised money “for carrying out an undertaking of great advantage, but nobody to know what it is”. For investors, they are bearing the risk of writing a blank check to a sponsor, and hoping that he can find the next Virgin Galactic, Nikola, or “undertaking of great advantage”.
Barron’s this week featured an article highlighting the issues surrounding SPACs. Reuters also reported that Billy Beane, of Moneyball fame, is looking to raise a $500-million SPAC.
Is the SPAC frenzy the 2020 version of the dot-com IPO bubble? Is SPAC activity a signal equity capital has become too cheap?
Another bull case for elevated P/E valuations is low interest rates. BCA Research pointed out that falling real rates are not only bullish for gold, but they are also bullish for P/E multiples as well.
John Hempton at Bronte Capital had the following thoughts about P/E ratios, interest rates, and valuations. It’s understandable why high growth companies like AAPL and GOOG attract high P/E multiples, but what about boring businesses like KO?
Interest rates are indeed low. If you believe that interest rates stay at zero forever then stocks whose earnings are unlikely to decline much (such as say The Coca Cola Company) should be valued at very high PE ratios.
Rather than just focus on P/E multiples, Hempton thinks that earnings are at risk:
We think – instinctively – that the aggregate earnings capacity of US business is at risk…
The corollary is that profit share is at historic highs, indeed, astonishing highs. Almost everywhere you look in the US you see companies that earn more than you would expect. Our personal favorite is Lamb Weston, which makes wholesale potato chips (fries to Americans) delivered to restaurants that wind up on your plate/hips. The 2019 operating margin of Lamb Weston is almost 18 percent. The operating margin of Apple, by comparison, is under 25 percent. The idea that a company whose sole job is to buy potatoes from farmers, chop them up, freeze them and deliver them to restaurants can earn margins even close to Apple is astonishing.
But what we see for Lamb Weston we see right across American society.
The American market is at above-average multiples of massively-above-average profits. Competition should usually drive down profit share, and democratic politics has – at least in theory and cyclically – some kind of redistributive effect.
While Hempton is concerned about the long-term trajectory of operating margins and earnings, the near term earnings outlook also faces downside risk. US households are falling off a fiscal cliff (see Fiscal cliff = Double dip). At publication time, the White House is still negotiating with the Democrats on a rescue package, but there is an enormous gulf in each side’s budget priorities.
Setting aside the economic and political pros and cons of each side’s proposals, here is the legislative math. There are about 15-20 Republican Senators who are adamantly against any further stimulus for philosophical reasons. To pass a rescue bill, the White House and Republican Senate leadership will need substantial support from the Democrats. As an illustration of Republican disunity, former Fed governor nominee Stephen Moore wrote a WSJ op-ed that blamed both the Democrats and Senate Republicans for the failure to pass a relief bill [emphasis added].
President Trump needs to reset the debate on the latest coronavirus relief bill. Senate Republicans have scuttled their best pro-growth idea—a payroll tax cut—and instead released a $1 trillion spending bill. Last week Mr. Trump acknowledged that compromising with Speaker Nancy Pelosi is a fool’s errand, because the House won’t agree to anything that boosts growth and job creation. The Democratic plan includes a six-month extension of the $600-a-week unemployment bonus and $3 trillion in new spending. It would sink the economy and imperil Mr. Trump’s re-election.
The lack of a Republican united front puts the Democrats in the driver’s seat if a CARES Act 2.0 is to be passed. What will they ask in return? How about most of the provisions of the $3 trillion HEROS Act passed in the House? What about funding for the Post Office to facilitate universal mail-in voting in November?
The Washington Post reported that “Pelosi, Mnuchin and Meadows all appeared on talk shows Sunday morning and indicated they were not close to a deal”. At some point, each side will have to make the political calculation of what they want and what they are willing to give up in order to a rescue package, compared to allowing the economy to go over a cliff and blame the other side. Viewed from that perspective, the odds of a deal are slim.
Stresses are already appearing in the economy in the form of skyrocketing bankruptcies, and that’s before the economy fell off the fiscal cliff.
The July Jobs Report has the potential to be a big negative surprise. Indeed.com reported that, even in an outperforming industry like tech, job growth has been stagnant.
Something’s gotta give. Street analysts have been revising EPS estimates upward, but the near-term downside risk in EPS estimate revisions is enormous. If and when they start falling, expect stock prices to adjust downwards accordingly.