What have we learned about the economy and the markets in the past few months? Bernstein Research's Senior Quant Analyst Ann Larson joins The Pulse to discuss our takeaways from companies' earnings reports, how Tech stocks can still be Value stocks, why "improvers" might make the best ESG investments, and more.
00:02 - 00:33
How everybody and welcome to The Pulse, where we cover trends in the economy, markets, and asset allocation for long-term investors, I'm Matt Palazzolo, a senior investment strategist at Bernstein and head of our Investment Insights team. I'm excited today to be joined by Bernstein, researchers, US quantitative senior analyst, and Larssen so and has a great top-down view of the overall market and lessons from the latest round of quarterly earnings and a range of other perspectives that we thought would be useful to discuss with you today. And welcome to the show.
00:33 - 00:34
Thank you so much for having me.
00:34 - 00:58
So and we just finished a round of quarterly reporting for earnings that the first-quarter reports and many of the analysts have updated their models and their outlooks. And I know you have to this is something that you watch really closely and you've been publishing on for a number of years for listeners' benefit. Before we get into the trends that you saw. What is it that makes earnings season so important?
00:59 - 01:39
That's a good question. So earnings season is a time when the companies really give you new news, right? So that's a time when you get a lot of news, not just on earnings, but also on revenues and all the other fundamentals. You get guidance from the companies on how they think they're going to do next quarter for the rest of the year, and how they think business is going. Then you also see, because it's watched so closely by other institutional investors, you do tend to see big price moves associated with either the earnings announcement itself or what the company said in the call following the earnings, whether they said anything interesting about future quarters.
01:39 - 01:58
Yeah, OK, good. And there's obviously not only the report that comes out but also the conference call. So you get a lot of that incremental detail that your team and the rest of the street look at closely. So if we think about the first quarter, which just concluded on March the thirty-first, and the reports that came out subsequent to that, what stood out to you this time around?
01:58 - 03:02
Also, earnings growth was really strong. On average. We saw twenty-two percent earnings growth on eight percent revenue growth. So sales year over a year went up eight percent earnings. Twenty-two percent. The number of companies that beat the Street's estimates were 90 percent and 90 percent of the sell side's estimates for earnings. So that is a 13-year high. That's extremely high. The average is seventy-eight percent. Most companies will sort of guy the sell-side analysts down to the number they can be. The number of beats is usually high to start with, and this just blew away those numbers. We saw really good results from financials, technology, and consumer discretionary. So some of those recovery trades in retail and so forth. And we've also seen that the magnitude of the surprises is very high relative to what we've seen in the past. So usually the companies beat estimates by three to five percent above the sell-side consensus. And this quarter it was 12 percent, a lot more company beating than usual.
03:02 - 03:25
But the amount that they are exceeding the consensus by is also very high on a more broadly held beat across the board for companies and sectors. And then when they beat, they beat by even more than they normally do, I would assume. And that that that would have led to some pretty good price movements for those companies that did beat after they reported that. True or not true?
03:25 - 04:12
Not really. Is that beat on both earnings and revenues went up by about one percent. And the companies that missed on both those numbers went down by about two percent on that day that they reported, you're saying, yeah, it was a two-day window. And so the reason that we look at windows around is sometimes the number gets out and people whisper numbers, things like that. So we do some performance around the announcement date and a lot of companies beat by a tremendous amount and they actually underperformed on the print. And the reason for that is investors know that these numbers are quite exaggerated because last year the height of the pandemic was a disaster.
04:12 - 05:04
Right. So it was a given that companies were going to be announcing pretty great growth. When you look at it, year over year, twenty, twenty-one, over twenty. And the market had a tremendous run-up for earnings and priced in a lot of this good news. And so we thought that there might not be as big of a reaction as usual because the market was kind of ahead of itself there. And then the final reason I think that we didn't get some outsized reactions to some outsized earnings announcements is because companies are looking through this quarter. So like I said, they knew it was going to be a great quarter. But what's going to happen after that year over year when whenever you have earnings that are really depressed, of course, you have easy compares and that's what happened this quarter. It's actually going to happen next. Again, they want to know what's going to happen in the back half of the year.
05:04 - 05:08
Do all companies give guidance or only a select number?
05:08 - 05:42
No. So not all companies give guidance in the first place. And the number of companies giving guidance dropped dramatically last year as companies just didn't know what their earnings were going to be because we've never had a pandemic before and everything was changing. And so a lot of companies stopped giving guidance. And the sell-side analysts really depend on guidance from the company to make their forecasts. And so this year we've seen a rebound in a number of companies giving guidance, but it's still really not back to pre-pandemic levels.
05:42 - 05:50
So. Twenty-two percent earnings growth in the first quarter versus the first quarter of last year. What are you what's the street expecting for the balance of the year?
05:50 - 06:05
The estimates for the rest of the year are also very high. So Q2 is even higher forecast at 60 percent year over year earnings growth than we saw in the first quarter. So 60 percent for Q2.
06:05 - 06:13
And I guess that's because that's when everything fell apart. We have a full quarter Q2 of twenty 20, whereas maybe it was one month in Q1 of twenty twenty.
06:14 - 07:21
So mid-March was kind of when everything shut down. So the second quarter of twenty twenty was the worst quarter of the pandemic. And so now you're going to see huge earnings growth next quarter and then for the rest of the year still very positive. Twenty-two percent earnings growth forecast for Q3 and 16 percent earnings growth for Q4. So usually what we see in a normal year is that as the quarter is approaching, they're sort of overly optimistic at the beginning of the year that things are going to be better than they actually wind up being. And so as earnings season approaches, the analysts are usually cutting estimates in this case because of the lack of guidance and the uncertainty. The analyst just undershot. Right. So the companies are beating said by larger margins than usual and the analysts are raising estimates to try to catch up. So usually we would say, oh, yeah, these earnings growth numbers for the next three quarters are too high and they're probably going to come down as we get closer. But actually, the opposite has been happening and the recovery has been so strong that they've actually been raising numbers into the quarters.
07:21 - 07:38
And so how does valuations play into all of this? As you look at the universe, there's obviously expensive stocks. A lot of our investors and clients talk about the market being expensive. How does that play into earnings season and what it might portend for the balance of the year in terms of price action?
07:38 - 08:07
That was another sort of dynamic that we saw going on with reactions to earnings. Right. So when we said that the market had a huge run-up earnings and that sort of dampened some of the reactions to these great numbers that these companies are reporting, we actually saw a consistent pattern of the most expensive companies were the ones that had the worst reactions, regardless of what they reported. So a lot of them reported just spectacular numbers across the board. But because they were so expensive, they didn't budge.
08:08 - 08:15
Many people worry about the technology sector as it relates to valuations. What did you see coming out of Q1?
08:15 - 08:58
Looking into the balance of the year for tech technology has had a huge run, has led the market, especially the big-cap technology stocks up until this year. Pretty much. Right. So we've seen huge outperformance of the top five, top 10 mega-cap technology companies or the technology sector in general. And up until this year, that has been led by superior earnings growth. So it made sense in a market where you're basically at zero rates and the technology sector has better earnings than everyone else, that the technology sector would lead. And it did. But now with the recovery, there are plenty of other sectors that have better earnings growth than the tech sector.
08:58 - 09:01
Right, because they're more cyclically sensitive, right?
09:01 - 10:06
Exactly. And so when growth is scarce, people will chase it at almost any price. And they did. Right. And that's what that's what led to the run-up in the technology sector. Now, what we're experiencing is that other sectors are posting better growth because of the economic cycle and the recovery and where we are. We've seen a 50-year high in the number of unprofitable stocks in the tech sector. So we have a lot of these sort of dream stocks where they're not going to make money for the next year or the next five years. But there are some big story or hope or long-term forecasts that they will make money far into the future. That, unfortunately, is bad news when rates are rising because those are long duration stocks and those tech stocks, these unprofitable tech stocks are going to be at a disadvantage when interest rates are going up. What short duration stocks, stocks that are making money right now, which tend to be more value stocks, are the ones that have an advantage. So for a long time with rates. Low or near zero, technology, when you're talking about discounted cash flows, had the advantage.
10:06 - 10:59
Now short duration stocks, which are typically more in the value sectors, have an advantage is a really interesting point just for our listeners and is bringing up a nuance point about duration, i.e. sensitivity to movements in interest rates either long duration or short duration, typically a bond term. But we're using it here to talk about equities. And that's been in the conversation amongst the Wall Street analysts and portfolio managers for quite some time, because these longer duration companies, like many of the technology and growth stocks, have done well as interest rates have fallen. And if it were to be the case that interest rates were to rise and be on a sustainable path higher, that might be a headwind for those companies that did do well as rates fell. The opposite would be true, very similar to fixed income that bonds that have sensitivity to rising interest rates.
10:59 - 11:11
And I want to move on. But you had said something about value stocks. I want to bring these two elements together. Technology and value are their value-oriented technology companies.
11:12 - 12:26
Yes, that might seem impossible, though. Technology is a sector where you can take a barbell approach. This is not true in most sectors and most sectors. The sector itself is either a value sector or both sector. And in the tech space there are value stocks and growth stocks. So some of the value stocks would be like IBM or some of the hardware names versus the sky-high apples and all the mega stocks. So what I mean by barbell is you can make money in the technology sector by owning both the value side of the continuum and the growth side. As long as you stay away from the middle or the middle is what we call growth stock purgatory, basically, because they're not cheap enough to be to be interesting to value investors, but they're not growing fast enough to be interesting to growth investor. So they're just kind of stuck in the middle and they're not really attractive to value or growth investors and they just languish there. So that's what's interesting about the tech sector. So when value works and tech tends to be in environments like we're in right now where we're seeing big value rotation, they're benefiting from that. Also times when there's a thirst for yield. So these stocks typically pay dividends, whereas the faster-growing tech stocks do not. So in those kinds of periods, we do see pretty good performance for the value side of tech.
12:26 - 12:46
Let me just dig a little bit further on this. Typically, when we talk about value, it's because companies value because it had some blemish, some issue that they had to deal with. Is that the case here or are these technology value companies just not the growth of your technology companies? And so for their valuations, take the hit?
12:46 - 13:54
There were are secular headwinds that we see with a lot of the value side of tech, with the hardware industry. As an example, the prices of hardware is coming down and the benefits of software having the subscriptions that people pay on a regular basis, having these recurring revenues and that whole model of the software industry versus the hardware industry is really a challenge for hardware and software. So you've seen software just having a huge run over the last few years and hardware just sort of having a hard time. So I think that this is something that we think about when we talk about the rise of intangibles and in the market and how things like the customer subscriptions and recurring revenues really factor in to valuations and don't really get reflected in the typical valuation ratios that we look at, like price to book and price to earnings. Right. And price the cash flow. So maybe those software stocks at 40 times earnings aren't as expensive as you might think because the intangibles are being properly accounted for. That is a whole different topic unto itself. But talking about the valuations as a software versus hardware, I think that's a great point.
13:54 - 14:25
Just just to go through all the different parts of technology. Technology is what, in something like twenty-five percent of the S&P? Five hundred. So it's the biggest sector by far. And it's not monolithic. It's not just one kind of stock or company. There's old tech, new tech value growth. And so I appreciate you bringing up that point. So so far, we've talked about the Q1 earnings, we've talked about the technology sector. We've talked about value within technology. What else are you talking about? When you go out and you talk to investors, what are the other opportunities out there?
14:25 - 15:00
I think there's a real opportunity for what we call quality on sale. So quality is something that a lot of our investors, a lot of our clients like. Right. So who doesn't like quality in anything, but particularly in the companies that you're going to invest in? The problem is that the way that we define quality is sort of in a multi-factor. So we look at things like ROIC, we look at earnings stability, we look at debt ratios, net cash ratios, we look at margins. And so we come up with a composite score of how does this company score high versus low quality and.
15:01 - 15:45
The problem is that these companies that are great, it's not a secret, so everybody knows which companies are higher quality, which companies are lower quality, and there's generally a premium already associated with high-quality stock. So in general, you're not going to get some huge bargain on the best stocks out there that I'm going to be the cheapest stocks out there. But the performance of quality tends to rise and fall with risk aversion. When investors are very risk off or risk-averse, they tend to have to quality. And you see those stocks really performing beyond the normal premium associated with those great companies. And then when you see that investors are willing to take on more risk and their risk on or less risk-averse, then you see the opposite happen. Right?
15:45 - 16:52
So right now, quality tends to outperform in a crisis, underperform on the way out. And we saw that happen last year at the height of the pandemic. We saw massive rotation into quality, low leverage, those types of stocks. And then this year, we saw the rotation out of those names, which were very expensive into lower quality or value names. And that doesn't mean that I think that you should just avoid quality stocks for the time being, because that has created some opportunities for some companies while not being the cheapest companies around have been unfairly sort of hit with the same brush as all these other companies. So what we call quality on sale. So they're great companies and they got sort of caught up in the recovery rotation and their earnings growth. So we're not talking about the companies where they say we're going to grow 10 years from now, 20 years from now. They're they're posting great growth right now. And they just sort of got caught up in the big wave. And so we we consider them to be great opportunities.
16:53 - 17:09
And if we look back over time, you talk a lot about factors or styles, these factors, these characteristics of different stocks. If you look at quality over time, has that been one where if you were to just hold quality companies for decades, you would have done better than the average stock?
17:09 - 18:29
Yes, I say that quality does have an alpha associated with it, but it's it's quite small. It's not as big as you would think it is. And that's because they're already priced for that level of quality. So you have to pay up if you want the best stocks around, the best companies around, the highest quality companies around. You got to pay up for it. And so that sort of eats into the returns over time. So there is a positive alpha. It's about one hundred fifty basis points. Maybe it's not as high a year, so maybe it's not as high as you might think it is. But that's because those stocks are already discounting that level of quality. What you really tend to see is sort of high quality versus low quality, sort of it's episodic. The performance tends to be episodic. That varies with the risk regime. So we were in a risk-off, risk-averse regime for a long time and that just actually increased when we got into the pandemic in twenty twenty and then late in twenty twenty and so far in twenty twenty-one. We're in a more risk on modes and investors are more willing to see that the recovery is happening. Where everything's going on, the economic front, everything's reopening, everything's great. They're willing to take on more risk and so they're not willing to pay up for the highest quality companies around. So that goes along with what I said earlier about when growth this year, people will chase it. It's not scarce anymore.
18:29 - 18:37
You've got a lot of work on ESG environmental, social and governance related investing. What what are your findings there?
18:37 - 19:16
Yeah, so this is really a growing area in the US. Europe is far ahead of us as far as incorporating ESG into their investment process in the US, it has been a little slower to catch on. So really in the last few years we've seen a big rise in interest in ESG. And I think from our investor base, one of the reasons why there's so much interest is because they see that flows have been when we look at the flows into all active funds, more of that is going into ESG funds and any other type of fund. In a way, it's a way for them to make money. That's where they want to be.
19:16 - 20:00
It's also true that it's what we call a defensive, active management, really. So there's a lot of passive products out there, ETFs that follow ESG scores. And there's been a flow from from active to passive that's been hitting the asset management industry for many years. Right. So ESG is a type of fund where you can really defend being an active manager, because to be successful, you could say, oh, I'm going to engage with these companies and convince them to be better over time. And we found that the companies that are improving versus the level again, the level of ESG is similar to what we talked about with quality, the ones that are the great responsible investors and have very high.
20:00 - 20:58
Sustainability rankings, there's already a premium associated with them, everyone wants to own the best in class. You're not going to get the best prices on those on those names now where you can really get some alpha or some performance with ESG investing is if you invest in the ones that are going to improve over time. And the problem with that is that they are the worst offenders, usually the biggest bang for your buck as far as Alpha with improvement is if they are one of the worst offenders already in the first place and then they get better, not the best stock getting a little bit better. What's really the bad ones getting better. And so active managers say we can engage with these companies and make them better over time. And that's a reason why you should invest in these activist funds versus passive. So that's why they want to get into this business. We've seen a huge rise in interest, both from the investor level, people wanting to buy these funds and asset managers wanting to open up these funds to satisfy that demand.
20:59 - 21:17
Well, I can certainly underscore and back up what you just said. We've got a lot of interest from many of our clients in investing responsibly. They want to align their values with how their money is managed. So this is a growing area certainly for us. And so we've built out that platform. So everything you said is spot on within Bernstine.
21:17 - 21:32
Before I let you go, and I want to ask you about this value rotation. You've touched on it a little bit as it relates to the recovery and the earnings growth and quality versus lower quality. Talk a little bit about this value rotation and whether or not you think it has legs.
21:33 - 22:03
We do think it has legs for a few reasons. So one is that when I talked about the risk aversion signal before, we actually measure that by looking at things like bond yield spreads and commodity indices or things like consumer sentiment, to come up with a composite score of whether the market is risk on or risk off and whether it's going to be that way for the next three months. And so far, our risk aversion signals are still risk on. And so risk on means that value factors tend to work better than, say, momentum.
22:03 - 22:35
So when you get a switch to risk on, the momentum factor is usually the factor that underperforms the most because you have now a trend change. Right? So before you had a flight to quality or risk, all the big quality stocks were outperforming and now you get to switch to risk on. That broke the trend. You don't have a new trend going it. You don't know what it is. So the momentum factors tend to fail during those inflection points. And when you're in risk on value tends to work much better than growth. That's one reason.
22:35 - 23:18
The second reason is that the Spurgeon's are still very wide. So we look at what we mean by dispersion is the difference between the cheapest stocks and the most expensive stocks or the cheapest stocks versus the market. So we want to see how much mis valuation is there in the market. Our cheap stocks, really cheap, sometimes are not right, sometimes very compressed. And so when you have compressed valuations, that means that you can get one of the cheapest stocks at the same price practically as the average and same thing for the expensive. So right now, there's still a lot of mis valuation in the market. Spreads are still really wide. They've come down a little bit from all time highs, but they are still wider than we've seen almost any time in history.
23:18 - 23:56
The final reason would be that we still see macro support. So value works best when the economy is improving. Also, when we think that we're going to see inflation and when rates are going up. So all of these things potentially are either already happening or are potentially happening. And we see that not only is that good for value in general, I mean, it's good for for example, to to big value sectors. Energy does great in inflationary environments. Financials usually do great when when rates are rising. And so we do see that this rotation probably still has legs.
23:56 - 24:04
Well, and thanks a lot for joining us. This was certainly very insightful. And given that we've got earnings season four times a year, we'd love to have you back.
24:04 - 24:06
I would love to. Thank you so much for having me.
24:07 - 24:43
And thanks to all of you for listening, we hope this conversation has shed a light on some of the interesting dynamics that are happening beneath the surface of the market. As always, we'll continue to monitor these data points and others and share all the evidence and what they're signaling with you here on The Pulse. If you've enjoyed this podcast, please subscribe and read us on Apple podcast or Google Play or Spotify or wherever you listen to podcasts and emails with your thoughts or questions or please any feedback that you have to insights at Bernstein dot com and be sure to find us on Instagram and Twitter at Bernstine. Thanks again and well.
24:45 - 24:51
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- Matthew D. Palazzolo
- Senior Investment Strategist—National Director, Investment Insights