Why Do Stock Prices Go Up Or Down After Earnings?
IMPORTANT: Please read the disclaimer before continuing.
In April and May, many listed companies reported their first-quarter results.
Meta Platforms (formally known as Facebook), Sea Limited, Alibaba, Alphabet, Snowflake, and Zscaler – these are some of the larger companies that I’m tracking.
On 27 April, Meta Platforms reported its first-quarter 2022 results.
(Source: https://investor.fb.com/)
Its revenue went up by 7% while its total costs and expenses went up by 31%. Since the costs increased faster than its revenue, its income from operations fell by 25%.
This is happening because Meta Platforms is investing in headcount to drive the business of Reality Labs.
If you are a shareholder, how would you feel?
For context purposes, Meta Platforms did not experience negative growth in its income since 2013. So, this negative growth was hard for some shareholders to swallow.
(Source: Google Finance)
Despite the results, the share price of Meta Platforms rose by 17.6% on the date of its earnings release.
If we look at Alibaba, its results came out on 26 May 2022. The company mentioned that its income from operations fell by 30%.
Similarly to Meta Platforms, the share price of Alibaba shot up. It did not drop.
If you’re wondering why the market reacts in such a puzzling manner, read on.
Look at the Big Picture First
Before that, let’s zoom out from individual companies and move into the broader market.
In 2020, covid-19 caused stock markets around the world to collapse. The S&P 500 index which represents the broader USA market fell by 30% in February 2020.
A month later, the S&P 500 index bottomed before staging a remarkable recovery to end the year with positive gains.
Did we recover from covid-19 within a month? The clear answer is no.
Here’s another example:
In 2008/2009, we experienced the global financial crisis. Speaking from the stock market perspective, the S&P 500 index bottomed in March 2009 before recovering. As for the economy, the crisis raged on for a few more months before the situation improved by June 2009.
Do you notice something here? The stock market recovered ahead of the economy.
While the economy and markets are interrelated, the economy is not the market. Similarly, the market is not the economy.
To elaborate further, the economic news will always be backwards-looking, reporting on what happened weeks or months ago. On the other hand, the market moves ahead of the economy.
It is forward-looking.
Market participants such as professional analysts, financial institutions, and retail investors adjust their outlook in anticipation of economic changes. They don’t wait for news.
Let’s go back to March 2020. The Federal Reserve supported the economy by pumping money into the economy and extending loans to support small businesses. Those actions restored confidence and investors believed the economy would not fall off the cliff.
That’s why the market recovered quickly. It even ended the year 2020 with positive gains.
In the same way, as of May 2022, the share prices of many growth stocks have collapsed. It’s because they moved in anticipation of future profits and interest rates.
Now, with this understanding, let’s look at individual companies.
It’s All About Expectations
According to SeekingAlpha, Meta Platforms missed the analysts’ expectations on the revenue side but outperformed on the income side. Market participants were anticipating lower profits since Meta Platforms was investing money into their loss-making segment called Reality Labs.
(Source: SeekingAlpha)
It turned out that Reality Lab’s losses were not as large as expected and the company was able to report a higher profit instead. Furthermore, a few days before its earnings release, its share price had already fallen slightly.
In essence, investors’ expectations were priced in prior to its earnings release. But they were wrong, so the share price shot up instead.
This forward-looking mechanism applies both ways.
On 25 May 2022, Snowflake, a cloud computing-based data company, grew its year-on-year revenue by 85% for its first quarter. The stock dipped because Snowflake’s results were not as good as what investors had expected.
How Can You Exploit This Phenomenon?
I have seen situations where a company misses the revenue by an insignificant margin, causing the stock price to drop 15% or more. Personally, I am more concerned about a company’s runway for growth than short term issues such as missing expectations.
It’s a huge irony to me that the stock prices of companies are being punished when these companies do not perform up to the expectations of analysts. Should it not be the other way around where analysts are being punished for failing to forecast the earnings of companies accurately?
I have no way to explain why the market is so reactive in the short term.
Fortunately, we can turn this situation to our advantage. How?
- Perform valuation work on your companies
- Know the range of prices where you can buy companies with a margin of safety
Whenever an unjustified sell-off happens, it becomes an opportunity for you to scoop up more shares.
This is not an easy thing to do because investors tend to feel validated when the stock market agrees with them. This is why they feel better when the stock prices of their companies go up in the short term. They may even buy more shares because they think they are right in their purchase. Vice versa, most investors would be frightened to buy more stocks when the share prices are falling.
This is why having the right temperament is important to succeed in the long term. As long as the long term thesis is intact, investors should make use of sharp drawdowns to accumulate more stocks instead of hoping to sell their stocks.
An investor should feel validated ONLY when a company continues to report higher profits over time and the stock price continues to move up for more than a year after purchase.
The more I think about exploiting this phenomenon, I’m more convinced that this is truly a competitive advantage for long term investors only, not for short term investors.
Short term investors cannot ride through volatility and they tend to sell stocks due to emotional reasons. Long term investors can ride through volatility because they have holding power.
You have to train your psychology well.
Summary
- The stock market is forward-looking. It sets the stock prices of companies based on expectations.
- When expectations are not met, a sell-off happens. When expectations are met, the share price stays stagnant. When expectations are surpassed, the stock prices go up.
- If you’re a short-term investor, you will care a lot about expectations. You make money when you’re right in your short term bets.
- If you’re a long term investor, you’ll focus more on a company’s potential to grow and whether you can purchase its shares with a margin of safety. You make money when you’re right in your long term bets.
- Being right in the long term is easier than being right in the short term.
- Seek validation from fundamental results instead of short term price movements.
We’re facing higher inflation and higher interest rates down the road. The market is already pricing a lot of pessimism into the share prices of many companies.
Three scenarios will play out from here.
Firstly, if the market is overly pessimistic and the situation is not that bad – the share prices of many companies will rally.
Secondly, if the economy is as bad as what the market is already pricing in right now – the share prices of many companies will stay flat.
Thirdly, if the economy is getting worse and the market has not priced in further downside risk – the share prices of many companies will fall further.