Issue 17: Earnings Season Is Upon Us!

Earnings season is upon us!

Decent Q4 results may belie weaker 2023 growth
Earnings season picked up steam last week, with some market-movers reporting results, including beats by Microsoft and beleaguered carmaker Tesla. As we await financial updates from the rest of corporate America, the consensus is that even if many companies managed to take the end of 2022 in stride, forward guidance will continue to be cautious, with the real pain in growth and margins set to occur in the latter half of 2023. Along those lines, despite Microsoft’s Q4 earnings yielding an upside surprise, Microsoft executives’ assessment of future growth spooked investors and caused the stock to plunge in last Tuesday’s afterhours session. We saw a similar pattern when the nation’s biggest banks kicked off earnings season a few weeks ago with good fourth quarter results offset by calls for an impending recession. Expect negative guidance to remain a theme as the remainder of last quarter’s results stream through.

Economic indicators jibe with CFO anxiety
Though market sentiment has shifted in recent weeks amidst China’s reopening, lower European energy prices, and renewed hopes that the Fed will pull off a ‘soft landing’, this is likely a temporary reprieve in recessionary expectations. Our base case remains consistent with companies’ gloomy guidance: the Fed’s restrictive policy, coupled with sticky cost increases, puts serious pressure on corporate profitability, sending the US into a recession by year end. Major economic indicators of industrial activity and consumer spending are already bearing this view out. Take US industrial production, for example, which saw its fourth consecutive month of declines in December, or manufacturing output, which fell for the fifth time in the last six months. Similarly, monthly annualized growth in retail sales (excluding gasoline, autos, and building materials) fell by 3.3% in December, in real terms.

Profit margins facing a squeeze
Of course, a slowdown in production and consumer demand will help on the inflation front, but these indicators should give pause to investors clamoring back into equities this year. With inflationary growth in costs and a sudden slowdown in revenues, profitability is bound to erode. If a recession is in the cards, some companies will no doubt find themselves with significant negative operating leverage as sales fall off quickly and unexpectedly, while fixed costs remain sticky in the short term. We’re already seeing a buildup of inventory in industries where less productive headcounts will turn into higher fixed costs, driving margins even lower. Unfortunately, some firms have added costs aggressively over the last year given continued strength in consumer demand, setting the stage for a painful reckoning as the cycle plays out.

Are fundamentals being properly priced?
One question on every investor’s mind is, of course, whether the bear market that began in 2022 also ended there. Sadly, we suspect the present rally is yet another bear market bounce. Indeed, some of the sectors seeing the sharpest rebound so far in 2023 are those like Communications, Technology, and Consumer Discretionary, which experienced the biggest drawdown in 2022 (see below). Meanwhile, defensive sectors—Consumer Staples, Health Care, Utilities—have sold off. Within well-performing sectors this year, companies in cyclical industries—chipmakers, chemical producers, steelmakers—have been among the best performers. In short, stocks are pricing in a relatively rapid decline in prices, Fed easing in H2, and good times ahead for rate-sensitive companies in leverage-intensive industries. Unfortunately, that perspective is at odds with downbeat forecasts by companies’ managers. We are inclined to put more weight on their informed views and proceed with caution.

Activists find opportunity in the bear market

Beaten-down firms bracing for shareholder activism
After a year of market declines, shareholder activism is ramping up. Elliott Management, one of the best known activists, is in the midst of a campaign for change within Salesforce, having accumulated a multibillion-dollar investment in the CRM software company as its stock slid throughout 2022. Other activist investors have been knocking on the door at big tech firms like Meta and Alphabet. Investors like Elliott typically accumulate a large stake in a beaten-down stock with a strong business model and underlying profitability, but structural issues in management and operations that hinder success. They use their ownership—often in coordination with other activists holding big blocks of equity—to secure board representation and push for change, potentially unlocking value and reaping large profits. Bear markets often present good opportunities to activists, who find plenty of bargains with such turnaround potential.

Activists more often targeting tech
Activists haven’t historically biased their campaigns toward new economy firms, although 2022 was a bumper year for tech targets. The trend has been driven by plunging valuations in growth stocks, which have been among the hardest hit in the current bear market, along with a pandemic era spending spree by tech firms, acquiring rival startups and rapidly expanding into new lines of business that didn’t always add much to the bottom line. Even so, outside of some of the more adventurous tech firms who have radically tweaked their business models in recent years—think Facebook’s disastrous foray into the Metaverse—many tech firms saw robust operating margins within their core business, creating favorable conditions for activists to enter the picture and push for divestment and cost cutting (e.g., high-profile layoffs in the sector since late last year), possibly providing a welcome catalyst for rebounding valuations in select tech stocks.