A world devoid of reliable earnings intelligence has made it impossible to agree on what the market is worth. For investors convinced they have an edge, that’s an opportunity they have waited their lives for.
Wall Street earnings forecasts are hopelessly scattered. A measure known as estimate dispersion — how much the highest and lowest per-share prediction varies on the average stock — has soared to near record levels, according to Bank of America data, making judging company prospects a huge challenge. It’s all because of the confusion created by the coronavirus, wreaking havoc in a market swinging 5% a day.
Big money managers and traders have begun to view it as proving ground for anyone capable of on-the-fly accounting and the hundred other skills that go into judging relative value in real time. It’s a throwback to Wall Street’s wilder days, a chance for money managers to rise above each other and the passive investing onslaught that has been their bane for more than a decade.
“This is a time for active managers to shine,” said Adam Phillips, director of portfolio strategy at EP Wealth Advisors. “Their ability to deviate from the indexes and dig into reports more will allow them to hopefully avoid some of those potential land mines and better position portfolios.”
Earnings season begins in two weeks and Wall Street is bracing for a host of challenges. Companies have withdrawn guidance, and analysts used to measuring their error rate on earnings estimates in pennies will be lucky to come within a dollar for some companies. Aware of this, traders have pushed options-derived measures of expected volatility on earnings announcement days to near double levels in normal seasons.
For someone like Scott Bauer, chief executive officer at Prosper Trading Academy in Chicago, the confusion is a potential gold mine. He’s watched as things that would knock stocks around — stock upgrades and downgrades, for instance — lost potency. At the same time, disagreement among analysts on earnings is creating all kinds of noise, widening bid-ask spreads in options and creating the potential for professionals to feast.
“It’s a massive opportunity for traders,” Bauer said by phone. “For a retail investor trying to get into a position, it’s not great. For a professional trader, it’s fantastic because they can take advantage.”
To be fair to analysts, the companies themselves have no real idea of their own prospects. Only 30 companies provided guidance in March, according to Bank of America, the lowest ever for the month in 20 years of data. On top of that, more than 50 have pulled guidance altogether, according to Bloomberg Intelligence.
That’s just fine with George Dai, senior managing director and co-chief investment officer of Weatherbie Capital LLC. His team has always relied on its own fundamental research and has been able to hold many more calls with managers of the companies their funds hold to gain a real-time picture of how companies are being affected. It’s a typical refrain that makes more sense in an information vacuum: the edge comes from a variant view.
“It is true that consensus numbers may be stale for the foreseeable future,” Dai said. “However, we understand the ‘intrinsic value’ of our companies, which we believe are market leaders in their fields.”
Bear in mind that a company’s performance against earnings estimates is a negligible factor in the long-term prognosis for its stock. A study by the McKinney consultancy found that firms that miss forecasts by 1% saw a share price decrease of just 0.2% in the days after the announcement. “Even consistently beating or meeting consensus estimates over several years does not matter, once differences in companies’ growth and operating performance are taken into account,” the paper found.
But opportunities for trading earnings reports go way up in a market as volatile as this. In the S&P 500, the average stock has swung in a 45% range in the past month. Entry and exit points are coming fast and furious in a market that saw its fastest 30% plunge ever, and also one of the quickest rebounds.
Three more investors on the opportunity:
Jeff Klingelhofer, co-head of investments and portfolio manager at Thornburg Investment Management: “We are active managers, we are fundamental bottom-up managers. This environment actually benefits us, but also similar shops. When you do have high earnings dispersion, it’s ultimately the ability of individuals and groups to come together, act in a collaborative fashion, express a view and ultimately hopefully be on the right side. What we had been doing is upgrading portfolios, taking advantage of the broad market sell-off to buy good quality companies, free cash-flow positive, relatively low debt levels that we believe will emerge on the other side.”
Gene Goldman, chief investment officer at Cetera Financial Group: “It’s a huge opportunity. I’ve been saying active managers are going to come back eventually. You need to see a more frothy, volatile market and international outperforming the U.S. and we’re starting to see that. A larger bigger firm with vast infrastructure will do well. It’s their access to research, they are not indiscriminately buying the entire index, they’re getting more information. With their grassroots research, active managers are going to do really well in this environment.”
Mike Stritch, chief investment officer for BMO Wealth Management: “For us it’s all about distribution of outcomes, weighting anything that can help us narrow down the probability, these are the possible trajectories they could take. From that work, that’s how we’ve been trying to gauge relative value and attractiveness of the stock market, as opposed to taking one view that this is the company’s estimate. For us it’s all about scenario analysis.”
The set-up is a welcome one for stock-picking funds that have had a hard time proving themselves amid the worst quarter for the S&P 500 since 2008. Less than half of actively managed funds beat their benchmarks in the first quarter, according to data compiled by Jefferies. Forceful selling pushed everything lower together, sending correlations between stocks to the highest levels since 2007 — a hard environment to thrive in.
But if past is any precedent, better days are to come. According to Jefferies’ Steven DeSanctis, active managers performed well “for an extended period of time” coming out of the dot-com bust and the financial crisis.
An earnings season with a lack of consensus could speed things up.
“The market will continue to be very confused — we’re always looking to find signals versus noise,” said Erika Karp, founder and CEO of Cornerstone Capital Group. “With any company guidance, they are telling everybody the same thing at the same time. If you want to get an investment edge, company guidance doesn’t buy you anything.”
–With assistance from Claire Ballentine.
This article was provided by Bloomberg News.
