Here's how to capitalize when the market gets it wrong.
May 18, 2022
Quarterly earnings season is predictably a source of outsized volatility for individual stocks. But unfortunately for short-term traders, it’s extraordinarily difficult to predict whether that volatility will mean a post-earnings pop, drop, or (less likely these days) a neutral “meh” reaction from the market. That’s why I personally avoid opening new positions in advance of earnings with the intention of taking advantage of a particular directional move.
That said, opening new positions (or adding to existing ones) after earnings is a different story. With a slew of quarterly reports every three months comes a fresh trove of invaluable information to help investors better understand the state of the businesses underlying the stocks they own. And make no mistake: Opportunities are often created in the process for patient, long-term investors looking to put some cash to use.
Nuance is always required, as we must account for everything from valuation contractions (or expansion), changing growth rates, inflections in profitability and shifting addressable markets.
But we can generalize several of the most common situations that tend to create buying opportunities in a manic earnings season. Here are three I believe are easiest to identify:
First is perhaps the easiest to spot: Stocks that get absolutely hammered — sometimes to the tune of 20%, 30%, or even 40% or more in a single day following earnings — as the market laments a limited section of an otherwise strong quarterly report.
But how do we know whether such steep declines are merited or if they represent actual buying opportunities? For one, the long-term thesis must remain intact (Read: “Where will this business be in three to five years or more?”), which implies the point of contention or headwind(s) that irked the market should prove temporary.
UiPath (NYSE: PATH) is a fantastic recent example. On April 1, 2022, shares fell nearly 30% after the robotic process automation (RPA) software specialist posted stronger-than-expected Q4 2021 results, but also followed with conservative forward guidance due to a combination of outsized ARR growth and uncertainty in Europe amid the war in Ukraine. On the former — that is, putting aside the one-time adjustments to guidance from European strife — UiPath’s top-line growth appears to be slowing significantly given outsized growth from its Automation Cloud product. UiPath Automation Cloud was launched just over two years ago and focuses more on driving annual recurring revenue (ARR) on an ongoing basis rather than through an upfront licensing model. Higher ARR from products like Automation Cloud tends to mute reported revenue growth in the near-term due to the way revenue is recognized ratably under such contracts, but should mean more predictable revenue streams in the coming years. This created buying opportunity if I ever saw one.
One note of caution: In these cases, you must be patient as you open or add to your positions. We’re not talking about taking advantage of a temporary bounce as such stocks inevitably rebound from oversold conditions. To the contrary, all too often such stocks continue drifting lower over the ensuing months until signs of improvement begin to materialize. But over the long term assuming improvements do indeed materialize, these drops tend to offer investors fantastic entry points for strong businesses — and end up looking like little more than blips in the radar years down the road.
Next, look for businesses whose stocks have gotten pummeled due to fundamental misunderstandings of its results.
Here again, these kinds of drops can take several months to resolve (depending on the gravity of the misunderstanding). But they’re arguably just as attractive in terms of the opportunities created for patient, long-term shareholders.
Lemonade (NASDAQ: LMND) is a good example of this phenomenon. In February, the insurance technology (insurtech) company saw a chorus of bears lament its spiking gross loss ratio, which worsened by 23 percentage points year over year and 19 percentage points sequentially to a painful 96% (far above its goal of sustaining a gross loss ratio of 75% or lower across all insurance products). At a glance, it appeared as though Lemonade’s AI-powered underwriting models were failing, generating outsized losses for the yet-to-be-profitable insurer.
However, that couldn’t be further from the truth: Lemonade management explained that its loss ratios had spiked due to outsized growth in the books of business for its newer home and pet insurance lines, which “demonstrate higher loss ratios than our more mature, stable renters book.”
Lemonade management further insisted they continue to expect loss ratios across all lines to drift lower as their respective books of business mature. Sure enough, Lemonade’s gross loss ratio improved to 90% in its most recent quarter (Q1 2022), and I suspect we’ll see continued improvement going forward. In time, I believe Lemonade’s share price should follow.
Finally, there’s reason many of the best investors focus not on turnarounds of struggling businesses, but rather on adding to their winners: Those winners tend to keep on winning.
This might not be as exciting as capitalizing on kneejerk overreactions or misunderstood strength. But this is perhaps the most effective of the three opportunities I’ve outlined in terms of predictability. By focusing on high quality names that are being held back despite consistently posting exceptional results, you can be reasonably sure the share price of such stocks will eventually reflect their true underlying value.
Financial holding company Markel (NYSE: MKL) might be my favorite go-to in this realm. A cornerstone of my personal portfolio for more than a decade, the so-called “mini-Berkshire” consistently posts excellent results with its three-tiered approach (investments, insurance, and a diversified group of acquired businesses) toward growing its per-share book value (which has increased at a compound annual rate of 10% for the past five years) en route to steady market-beating gains.
Case in point: Markel shares were badly lagging the market leading up to the eyewatering peak in growth stocks last year. Now, even as roughly half of all stocks listed on the Nasdaq Composite index are down 50% or more from those peaks, Markel steadily marched to a fresh all-time high last month before pulling back a modest 12% as the markets effectively crashed. Even today, with shares trading around 1.3 times book value as of this writing, I certainly don’t mind being able to take advantage of this steady winner being held back by broader market turmoil.
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