In another oddity brought about by COVID-19, it’s the summer of 2021 and my recent evenings have been consumed cheering on Team USA at the 2020 Tokyo Olympics. And while the pandemic impacted event lacks the vibrance of arenas full of impassioned fans, the Olympics maintains its great spectacle and athletic excitement…as well as expectations that are occasionally unrealistically high for our American athletes. I enjoy tuning in every few years and becoming engaged with sports I otherwise disregard, allowing the touching NBC-crafted stories and past dominance of our athletes to shape my expectations for what’s to come.
The influence of expectations also plays a critical role in investing, particularly for stocks considered to be growth stocks. Stock analysts value a company largely by the earnings and cash flow expected to be produced in the future. Accurately forecasting these future earnings is a difficult task for even the simplest and steadiest of businesses but is particularly challenging for companies that are rapidly growing.
In determining the value of a company today, analysts develop assumptions about the pace of business growth and closely watch whether actual results track with their predictions. Businesses that exceed those (sometimes lofty) predictions tend to be rewarded, while those who fall short are commonly penalized even if the absolute performance was remarkable.
This dynamic was on full display last week as the Tech Titans reported their most recent quarterly earnings. Broadly speaking, they reported exceptional quarters with revenues and earnings growing at rates most companies can only dream of attaining. Despite these impressive results, the stocks for these companies faltered.
- Facebook beat earnings estimates by 20% and grew revenue by 55% compared to the prior year and was rewarded with a -4% stock decline.
- Alphabet beat estimates for both earnings and revenue while its search business grew 69%, producing a modest stock decline.
- Apple? Beat, beat, stock down -1.2%.
- And finally, there was Amazon growing earnings at an impressive 22% compared to the prior year and comfortably exceeding estimates, but revenue was below predictions and its stock declined more than -7%.
What drives the disconnect between tremendous business performance and falling stock prices? Expectations. When an athlete is expected to win gold but brings home silver despite besting the previous Olympic record, we’re disappointed.
Likewise, while Amazon has consistently beaten revenue estimates every quarter back nearly to the 2018 Pyeongchang Olympics, its quarterly results missed analysts’ expectations, and Amazon’s guidance suggested the rate of growth in the upcoming quarter would be a paltry 16%.
Diversification of Fandom and Investments
For these companies, not living up to high expectations causes investors to reassess the long-term growth rates. And when confidence in the sustainability of outsized growth has been shaken, the result is a reduction in projected value. Growing fast is good, but growing less fast than expected is bad.
While we can’t control the outcomes for these businesses or the assumptions used by the analyst community, we can seek to build portfolios that are resilient to adverse developments within any single industry or company. This includes diversifying portfolios across asset managers’ investment styles and using diversifying strategies we refer to as complementary investments. Broadly diversified portfolios remain an investor’s best defense in a world in which both stocks and bonds are richly valued.
As an Olympic spectator in the modern world I can diversify my fandom easily, quickly moving on from any disappointing outcome with a quick channel change to where I can promptly cheer on another of my fellow Americans in the pursuit of excellence. From the beaches to the pool to the track, I’ll continue rooting for our athletes while trying not to be too aggressive with my expectations.