The Expectations Game
We’re well into earnings season and we are seeing certain sectors posting pretty extraordinary growth numbers. Companies involved in e-commerce, for example, are experiencing huge spikes in revenue as consumers adapt their spending habits and rely more and more on online shopping in the wake of the CV-19 pandemic.
However, posting great numbers doesn’t always mean the stock is going to go up the next day. Case in point, Etsy (our current Stock of the Month), recently reported a 137% increase in revenue, but the following day, the stock actually went down about 4%.
So, why would that happen?
I’m going to start by saying that worrying about a small drop in share price on a given day is not a very good use of one’s time. An earnings report covers a company’s performance for about 12 weeks — sometimes you’ll see good figures, sometimes you’ll see not-so-good figures. If you’re investing for the long-term, one earnings report shouldn’t have much of an impact on your investment thesis. Occasionally you will get one where the company has really been hit hard and announces something that could result in your thesis being broken, but we’ll discuss those another time.
Here are some reasons that a stock might go down after what appears to be a good earnings report.
1. Expectations of Analysts
Over the short term, stocks move in line with sentiment and expectations. It might sound like 100% revenue growth is incredible, but if Wall Street analysts were expecting 110% growth, the expectations haven’t been met and the sentiment sours.
2. Expectations of Investors
Oftentimes you will see a stock’s share price increase quite substantially in the lead up to earnings. This is investors buying into the stock in the expectation that it’s going to beat expectations and see a short-term pop. However, a lot of the time, even with a good report, the stock doesn’t see a pop and those investors take whatever profits they have made and the stock drops. In the Etsy example shown above, the stock had increased by about 15% in the days leading up to the report.
3. Expectations for the Future
The stock market is a forward-looking mechanism. It doesn’t really care about money that’s already been made, it’s focused on what money is going to be made in the future. A company could post amazing growth in the quarter just gone, but management might be cautious regarding the quarter or year ahead. It’s worth noting that many management teams prefer the underpromise/over-deliver approach to guidance (I’m looking at you Wix), so don’t be surprised if they smash past their own expectations the next time around.
4. Mr. Market
Some days Mr. Market is just in a bad mood. It doesn’t care if a company has posted strong earnings. When Mr. Market wants all stocks in the red, all stocks are going in the red.
Short-term stock movements are influenced by earnings reports, analyst updates, investor sentiment, and valuation multiples. Long-term stock movements are based on talented management, economic moats, company culture, and reinvesting profits to grow the business. The former are fickle and incredibly hard to predict. The latter are stable and identifiable.
Focus on the latter and you’ll be a far more successful investor.