Brian Mackey: Hi everyone, this is Brian Mackey, deputy director of research at Adviser Investments. Welcome to another episode of The Adviser You Can Talk To Podcast.
Brian Mackey: Today, we’re going to talk about one of the most important factors in determining how much a company’s stock is worth—their earnings. We’re going to cover all the bases, from what is and is not included in earnings to why Wall Street is so focused on quarterly profits. I’m excited to be here with Kate Austin, who is an equity research analyst at Adviser Investments and a member of our dividend income team. Kate earned her M.B.A. at Boston College, where she studied Warren Buffett’s highest-grossing investments. At Adviser Investments, she spends her time researching underappreciated dividend-paying stocks. Kate, welcome to the show.
Kate Austin: Thanks so much for having me. I’m excited to be here and talk about earnings. I always say earning season is the most wonderful time of year, but unlike Christmas and Hanukkah, it comes four times instead of just one!
Brian Mackey: More gifts! All right, so let’s start with the basics. What are earnings?
Kate Austin: The easiest way to think about earnings is to just think profits. Earnings are the way that investors measure how a company has done over the past quarter, or three months. Profits matter, because that’s what’s going to drive a stock price either up or down, since the value of a stock today is all the future profits from that company. A famous portfolio manager from Fidelity, Will Danoff, always says that a stock’s price follows its earnings.
Kate Austin: The best way to think about this is through an example. If you think about a company like Macy’s, they might sell a t-shirt to you for $20. But there are more costs associated with that $20 than just the cost of the materials that go into the t-shirt. You have to also think of the salary of the person that sold you the t-shirt, the rent on the building that Macy’s is sitting in and the cost of shipping that shirt from wherever it was made to you. All of those costs have to come out of the $20, so Macy’s may only keep $1 of the $20. That $1 is the earnings, or profits—but on a much larger scale.
Brian Mackey: Yeah, it sounds like the shareholder cares about that $1 in profits for Macy’s, because out of $20 that Macy’s might get from that shirt, $19 is going to other people. As a shareholder in the stock of Macy’s, you care about what’s profit is available to the equity shareholders.
Kate Austin: Exactly.
Brian Mackey: So you might have $19 going to other people, but that $1—and if that dollar is going to grow—is what really determines what the stock price of Macy’s should be.
Kate Austin: Exactly.
Brian Mackey: Okay. You mentioned that every three months or so, a company will report their earnings. There’s some volatility that we tend to see: The stock might be up or down after they report. Why is that, and why are expectations in earnings so important?
Kate Austin: Typically, management will give investors and analysts what we call “earnings expectations” where they think earnings will come in. It’s typically a range. They give it to you for the next quarter as well as for the full year. This is where analysts kind of build what we call earnings expectations. They’ll take what management will tell them and then put a shrewd eye on it and put it against their models of what they think is going on with the business and come up with earnings expectations.
Kate Austin: The reason why everyone cares so much about expectations is because whether a company will miss or beat their earnings expectations will have an effect on the stock price. You may remember at the beginning of 2019, Apple guided their fourth-quarter earnings estimates down significantly due to slower than expected iPhone sales; and, subsequently, the stock fell about 10%. Since then, the stock has recovered, but this is an example of how earnings and earnings expectations can really affect stock prices. An earnings beat or a miss is against those expectations.
Brian Mackey: It reminds me of growing up with my sisters and my parents would expect my sister to get an A. When she came home with a report card and it had an A in it, that was not a big deal. But if I came home and had an A, it’d be a steak dinner for the Mackey household that night. It was a big deal if a B student came home with an A, and that was just expectations being reset in the Mackey house. The same thing happens in the stock market.
Kate Austin: Exactly. And your parents are the typical investor. If your sister comes with an A, and that’s kind of what analysts were expecting, the stock might move a little bit. But if you came home with an A or a C, that would be something significant and the stock price would move up or down based on that.
Brian Mackey: Interesting. So what about Wall Street, then? You mentioned there’s this three-month period where companies are reporting, and there’s this volatility. Is Wall Street overly focused on quarterly profits?
Kate Austin: Yes, but Wall Street is focused on quarterly profits because they have a much shorter time horizon or holding period than your typical long-term investor. When we say Wall Street, we do mean the investment community at large. But like we talked about, Wall Street is really focused on earnings because that’s what your typical investor will get. The holding period is really the bigger difference. Wall Street tends to only hold investments for maybe three or six months at a time, where here at Adviser Investments, we are long-term investors, so we might hold a position for maybe two to five to ten years. Earnings are a good snapshot, but again, it’s only showing a three-month period. This short-term mentality can really kind of miss some of the overarching changes in the world and the business model, in general.
Kate Austin: A few quarters ago, Netflix missed earnings estimates due to lower subscriber growth than expected; and, subsequently, the stock fell about 25% from its high. Then the next earnings season, the stock was up significantly due to better than expected subscriber growth. Companies will have ebbs and flows, and this is normal. But because Wall Street has a short holding period, they like consistency. That short-term mentality really punishes the company’s stock price when they do miss earnings because the future earnings of the stock are coming under pressure, which will, in turn, put pressure on the stock price. Remember, a stock’s price follows its earnings.
Brian Mackey: It sounds like Wall Street is focused on earnings, but earnings are important and they should be focused there. The bigger issue is that they’re just more focused on the short term as opposed to being a long-term investor, which is what we try to do here.
Kate Austin: Exactly.
Brian Mackey: We talked about why earnings are important, but maybe we should focus a little bit on what is not included in earnings.
Kate Austin: Earnings is one snapshot of how a business is doing, but it really misses two key factors: Reinvestment in the business and actual cash coming in the door. These are not captured in earnings, but they are arguably just as important. If you think about a company that doesn’t reinvest in its own business, it won’t be successful in the long term because they’ll become obsolete and their competitors will overtake them. A company that doesn’t have cash flow is not a sustainable business.
Kate Austin: There’s a company, you may have heard of them, GE, that was always really focused on earnings—always beating earnings by maybe a half a penny or a penny a share. But if you looked at how they were reinvesting in the business or how much cash they were generating, it really wasn’t in line with how well this company—or how well this stock—was performing. For a company like GE, we would expect them to reinvest in the business. If they were to build a new plant to make more power units, or purchase another company that’s doing that really well. Obviously, because they pay a dividend, you want to make sure that GE is generating enough cash to cover the dividend because that cash is going out the door every single quarter to shareholders.
Kate Austin: Because GE was not reinvesting in the business, they were overpaying for the mergers and acquisitions activity. They were having cash come out of their books every quarter to pay the dividend. They were really eating into their cash reserves, which is obviously not a good sign. Because they kept beating earnings, the stock price kept increasing. It really wasn’t until the beginning of 2017 that investors started to see the writing on the wall and realize there was a lack of cash, an overpayment for some of this acquisition activity, lack of integration of those acquisitions and the lack of reinvestment. Since then, the stock has fallen almost 70%.
Brian Mackey: It’s amazing to compare the story of GE to that of Amazon, where if in the mid-2000s, both GE and Amazon stock price were doing pretty well. However, GE was doing well because they were beating earnings expectations, as you mentioned. However, Amazon was just growing very rapidly. They weren’t making a lot in profit. Analysts were saying, “why don’t you return that profit to shareholders or buy back stock, pay dividends…”—those types of things. They weren’t doing that. They were reinvesting their money in the business. Fast forward to today, and Amazon’s done incredibly well. They’re one of the most valuable companies on the planet. Their stock has done very well. On the other hand, as you mentioned, GE stock, not so well. That focus on the long term is very important.
Kate Austin: Definitely. I think, when you look at both of these businesses it’s abundantly clear which business you’d rather own. It’s definitely Amazon over GE. But if you rewind back to the mid-2000s, both of these companies looked like really great companies, especially on just the earnings. It’s only when you got under the hood of the car and started looking at what was actually happening in the business that you could see some of these differences. I think it’s important to remember, too, that when you do buy a share of stock, you’re buying a portion of that business and, by extension, a portion of that company’s future earnings potential.
Kate Austin: I think it’s really important, too, to make sure that whomever is at the helm of the business that you’re purchasing has their goals really aligned with you as a shareholder. Jeff Bezos, a lot of his net worth is tied up in Amazon, so his interests are aligned with long-term shareholders, versus another C.E.O. of GE, John Flannery, who may come in for a few years, try and do the best that he can and then leave. He’s probably focused a little bit more on short-term investments over the long-term health of the business.
Brian Mackey: It reminds me of a saying that we have here: “We eat our own cooking.” When we look for mutual fund managers, we want to know that the manager has been running that fund for a long time and that they are invested in that fund. That’s a lot more like Jeff Bezos versus the John Flannery who was only there for a little bit and probably didn’t have a huge stake—certainly didn’t have a 16% stake in the company like Bezos did. We see the results, the short-term versus long-term outcome.
Kate Austin: Exactly. I think it brings in another point of another former GE C.E.O., Jack Welch, who always said, “Show me someone’s incentive structure and I’ll show you how they’re going to act.” It’s important to note, as shareholders, that the C.E.O.’s incentive package is aligned for the long term if you are a long-term shareholder.
Brian Mackey: For the long-term shareholders that are listening on this podcast right now, what should they be paying attention to when a company reports earnings?
Kate Austin: It’s important to look at the earnings report, as well as some of the other financial statements that will show the reinvestment in the business and cash flow because those are both very important too. It is important to look at how this quarter compares with past quarters. What are the numbers saying over a year or two? Is the business expanding or contracting? How is the stock price reacting to those things, too?
Earning season is also a great time to chat with management to get some overarching larger strategic goals—what the competitive landscape looks like. I think sometimes a bad quarter can really hurt a company’s stock price in a phenomenal business. But this really gives investors a great buying opportunity to take advantage of some of that short-term thinking that Wall Street uses to get into a phenomenal business.
Kate Austin: We will expect earning season to be a little bit more volatile just because there’s so much more information, but it is always an exciting time of year, four times a year!
Brian Mackey: Absolutely. I guess if I were to take three things from our conversation today, I think the first would be earnings matter. We wouldn’t be having a podcast on earnings if they didn’t matter. But if you own a stock, if you’re a shareholder in a company, then you’re getting the income that is derived from that company. You’re getting the profits, so you want to be paying attention to what those profits are.
Brian Mackey: The second takeaway I get from this conversation is that companies report earnings every three months, so there could be some volatility. The stock could be up or down quite a bit as the company reports and expectations are reset every three months when a company does report.
Brian Mackey: Lastly, while earnings matter, they’re not the only thing that matters. We’re also paying attention to how much a company is investing in their business. What is the actual business model, the overall strategy of the company? That will paint a much more complete picture of what you’re investing in.
Kate Austin: I couldn’t have said it better myself. We do want to keep a focus on earnings, because like the wise Will Danoff says, “a stock’s price will follow their earnings.”
Brian Mackey: Absolutely. Thank you, Kate. This has been Brian Mackey and Kate Austin, and we’d like to thank you for listening to another The Adviser You Can Talk To Podcast.
Brian Mackey: If you enjoyed this conversation, please subscribe and review our show. You can also check us out at AdviserInvestments.com/podcast. We love getting feedback from listeners, so if you have any questions or concerns, please e-mail us at info@AdviserInvestments.com. Thank you.