To borrow from Jane Austen’s opening to Pride and Prejudice, “It is a truth universally acknowledged that stocks rise because analysts raise their earnings estimates”. Except, like Austen’s own (vastly superior) version about wealthy men and matrimony, this market aphorism is not always true.
Case in point: the recent and stunning US equity market leadership from Apple, Microsoft, Amazon, Google and Facebook. Each is well above their old February 2020 highs. Each set fresh all-time highs on an almost daily basis. And collectively they are now 23% of the S&P 500.
Yet when you look at where analysts have taken their Q2 2020 numbers over the last 30 days, these estimates are either stagnant or actually declining:
- Apple: 2 cents revision higher, to $2.01/share
- Microsoft: 1 cent revision lower, to $1.38/share
- Google: 10 cent revision lower, to $8.03/share
- Amazon: 2 cent revision lower, to $1.34/share
- Facebook: no revision at all, $1.37/share
Perhaps it’s a longer-term sort of enthusiasm – maybe over 2021 estimates – that has the market excited by these stocks (spoiler alert: it isn’t) … A look at the 30-day changes in out-year estimates betrays this thesis as false:
- Apple: 1 cent revision lower, to $14.85/share
- Microsoft: 2 cents revision higher, to $6.23/share
- Google: 12 cent revision lower, to $55.07/share
- Amazon: 6 cent revision lower, to $37.50/share
- Facebook: 3 cents lower, to $9.72/share
We are left with the conclusion that these stocks are working not because of a sudden shift in the market’s perception of their earnings power, but rather because of incremental confidence that these 2021 estimates are actually achievable. In Markets we discussed the importance of operating leverage to the litmus test of which sectors merit fresh capital just now. A comparison of expected Q2 2020 and 2021 results for each name shows this phenomenon:
Q2 2020: expected to show -8% earnings on -4% lower revenues, both as compared to last year
2021: expected to show +20% earnings on +12% revenue versus 2020
Q2 2020: flat earnings (+0.7%) on +8% revenues
2021: +10% earnings on +11% revenues versus 2020
Q2 2020: -44% earnings on -5% revenues
2021: +33% earnings on +21% revenues versus 2020
Q2 2020: -74% earnings on +27% revenues (reduced earnings due to COVID mitigation)
2021: +99% earnings (not a typo) on +18% revenues versus 2020
Q2 2020: +51% earnings on +2% revenues (large charge Q2 2019 to settle litigation)
2021: +34% earnings on +25% revenues versus 2020
Take an average of these 2021 comps (ex Amazon) and you get expected earnings growth of 24% on revenue growth of 17%; that’s the very definition of operating leverage. Given the current state of the US/global economy, these are of course remarkable numbers. And yet the market is happy to pay anywhere from 25x 2021 earnings (Facebook) to 34x (Microsoft) because it sees a pathway to achieving (and perhaps beating) these estimates.
You know our perspective on PE ratios by now: they don’t tell you what stocks to buy/sell, but they do indicate how certain markets are about future fundamentals. As we’ve outlined here, investors have a great deal of confidence that Big Tech will deliver better results than any other set of companies. This quarter’s results will be spotty, as we’ve outlined. But as long as they don’t deflate the market’s confidence about future earnings leverage, this is unlikely to matter.