Is It Safe to Invest In An Earnings Recession?

IMPORTANT: Please read the disclaimer before continuing. Before you read this article, re-visit my previous article to get the full context of the content below.

Recap on Drivers of Stock Prices

Some of you might be seeing the term “earnings recession” on many financial websites. This article will help you to understand it and learn how to avoid a situation where the companies in your portfolio suffer from a huge earnings decline.

To protect your portfolio, you need to understand the 2 drivers of stock prices:

• The earnings of a company
• The price multiple of a company. A common example of a price multiple is the Price-to-Earnings ratio.

To demonstrate how the two factors relate to each other, refer to the table below:

In scenario 1 (normal market), a company earning $10 million of profits with a 20x price multiple will be worth $200 million. 

In scenario 2 (bear market), the same company is now worth $150 million simply because the price multiple compressed from 20x to 15x. It is still earning the same amount of money. That’s price multiple compression.

In scenario 3 (bear market), the same company is now worth $300 million. Despite still having a low price multiple of 15x, it grew its earnings from $10 million to $20 million. That’s earnings growth offsetting the price multiple compression.  

In essence, to make money investing in stocks, you want businesses with growing earnings and growing price multiples.

Using research by Morgan Stanley, we have previously established that revenue growth and profit margins matter more than price multiples. This is because price multiples can swing drastically depending on the sentiments of the markets. Whereas earnings are often influenced by management capabilities and industry tailwinds, and less by general market sentiments. 

How do we tell whether a company is suffering from price multiple compression?

Let’s take a look at Tesla’s Q1 results:

Total revenue and income from operations went up by 81% and 507% respectively on a Year-on-Year basis. Despite that, Tesla’s stock price went down by 43%~.

When a company has growing earnings and declining stock price, this means it’s suffering from price multiple compression.

In January 2022, Tesla had a price to sales multiple of 20x. In June 2022, it fell to 12x. 

(Source: Capital IQ)

Usually, this is fine because once market sentiments are back to normal, price multiples will go back up.

Now, in the next few months, things are not going to stay the same. We are about to face something called an earnings recession. 

What is Earnings Recession?

An earnings recession is when companies start to report lower revenue and growth. This could be caused by a slowdown in the economy or/and higher operating costs. In general, people are spending lesser money which results in companies earning lesser money. 

Consumer sentiment, measured by The University of Michigan, is at levels last seen in the previous global financial crisis. It is very weak right now. This means discretionary spendings on restaurants, entertainment, and shopping are likely to be badly affected. 

If you’re holding on to such sectors in your portfolio, you might want to reposition them.

An earnings recession is scary because once a company reports lower profits, its price multiple will be hit badly too – causing a double whammy to its stock price. When price multiples go down because of earnings, it’s called de-rating.

Here is an illustration: 

In scenario 4 (earnings drop + bear market), the same company is now suffering from an earnings recession. Its earnings dropped from $10 million to $8 million (-20%). On top of that, since it is in a bear market, its price multiple collapsed from 20x to 12x. As a result, its valuation dropped from $200 million to $96 million (-52%).

A 20% decline in profits can cause a 52% decline in stock price. A double whammy.

On 19 April 2022, Netflix shared its subscriber guidance. The stock market did not like it and reacted adversely.

Here is Netflix’s price multiple (Price-to-Sale):

This led to Netflix’s stock price crashing hard. 

Seeing such drawdowns is extremely painful for any investor. This is why we need to avoid earnings recession at all costs! We must differentiate which companies are going down because of price multiple compression, and which are going down because of an earnings recession.

What Are Some Safe Havens? 

To keep our portfolio safe, we need to look for companies with growing profits for the next 6 – 12 months. 

While most investors might look towards healthcare, consumer staples, and utility industries, some companies in those industries do not provide compelling growth. Walmart, a consumer staple company, reported a meagre 2.4% growth in its latest quarter.

Instead, here are some themes that I am looking at:

Mission-critical software companies that other companies are hugely dependent on.

Companies are unlikely to cut their spending in these areas.

1. Crowdstrike – companies still need cybersecurity.

2. Snowflake – companies cannot operate without access to their database.

3. Palantir – companies rely on Palantir’s operating system to make smart decisions to drive productivity and save costs.

Companies with early penetration into their respective industries.

For example, if a company has less than 10% market share of the industry, it is possible to grow even during bad economic times as it can steal market share away from its competitors.

1. Crocs – it is NOT selling shoes, it is selling various forms of self-expression. Skechers’ revenue is currently twice that of Crocs, implying that there is huge room for Crocs to grow.

2. Upwork – the world is gradually shifting towards a freelance economy and Upwork is benefiting from this tailwind.

3. Dlocal – it is simplifying cross-border payment transactions in Africa and Latin America where cashless payments are gaining popularity.

Finally, do not forget your valuations. Some companies mentioned above have growing revenues but their valuations remain expensive.

Summary 

• Earnings growth and price multiple expansion are two drivers of stock price returns.
• Temporary price multiple compression is fine because earnings growth is able to offset it.
• Avoid companies with declining profits because they will suffer from earnings decline and price multiple compressions. When this happens, its stock price will be badly affected. 
• Buy resilient companies that are able to report growing profits even in a recessionary economy.  

In closing, our psychology is very important in the next 6 – 12 months. This is why we need to have confidence in our companies.  

It’s one thing to see growing earnings and falling stock prices. It’s another thing to see declining earnings and falling stock prices. 

In the first situation, you will find it easier to accumulate more shares because you know your companies are becoming cheaper. In the second situation, it’s much harder to know whether a company can rebound.

Stay safe and happy investing.

PS: The BIGGEST mistake most investors make is to buy a stock when the price is “low”, thinking that if the stock returns back to its original price or all-time high, they can make a handsome profit. However, if you are holding on to a dying company with declining revenues, chances are it might never fully recover from a market crash.

But if you’re holding on to stocks with increasing revenue growth, then it’s highly likely that these companies would be resilient during a recession, and rebound even faster during a recovery.