If you’re helping someone save for a long-term goal like retirement, it’s important to give them perspective on short-term market swings.
Benjamin Graham, a famous investor and professor, whose approach to investing influenced many people, including Warren Buffet, wrote this about investing: “In the short run, the market is a voting machine, but in the long run, it is a weighing machine.”
This quote highlights an important lesson. From day to day, stock market movements might seem like a popularity contest. However, companies that grow their profits over long periods tend to see a higher share price, or generate steady or even growing dividends.
On any given day, it might be a tossup whether the Dow Jones is in positive or negative territory. But from year to year, it’s not nearly so even. Positive years far exceed negative years. The S&P 500 had a negative return in only one of the past ten calender years (source: Putnam).
The positive skew is even more pronounced over longer time periods. For 10-year periods starting back in 1928 — a total of 82 periods — buy-and-hold investors would have had positive returns in 78 of the periods, with losses in only four of them.
Help clients see the benefit of a long-term horizon
Fundamental investors focus on earnings
Professional asset managers can choose to follow a variety of approaches to investing.
Putnam Investments, a Boston-based company, manages equity mutual funds that select stocks based on a rigorous analysis of company earnings. The firm has been at it for over 80 years.
Putnam believes that over longer time frames, earnings matter most. The company’s investment teams spend the bulk of their time trying to get the earnings picture right for the hundreds of companies they analyze.
How do they paint an earnings picture? Stock analysts meet regularly with the management teams of the companies they analyze, and also talk with their suppliers, competitors, and customers. The teams build financial models, incorporating insights of sector experts to help determine their level of conviction in a company’s growth prospects. Different aspects of a company can play a role (see table).
Focusing on fundamentals
The market’s attention to just one of these categories could drive short-term stock performance. More often than not, some combination of two to three of these items is what matters most over the years, and the issues might be different than what the market is myopically focused on today.
Sorting through these possible drivers of return, Putnam teams try to find which ones are most important to each company they analyze.
Eyes on earnings
Putnam expects that, as earnings drive stock performance, prices should reflect positive earnings releases that are above expectations. The goal is to own companies whose outlook, supported by research, is better than the market anticipates. They look for not only how fast a company can grow earnings, but for durability of earnings growth at a level above the market’s expectations. When companies in the portfolio experience a positive surprise, it can have a powerful effect.
An earnings surprise is a term for a quarterly earnings report that is above or below the expectations of equity analysts. In a positive surprise, earnings are higher than expected, while a negative surprise is an earnings disappointment.
Often, a surprise causes a sharper move in a stock price, up or down, than on most days.
Earnings in the markets today
Investors who have read financial news over the past year may have a number of questions on their minds. The market took a nose dive during the last few months of 2018, and headlines carried stories about global trade conflict, higher interest rates from the Federal Reserve, and a slowing of the economy.
Fortunately, markets rebounded to open 2019, and have gained back much of the ground that was lost in 2018. News headlines have also carried more encouraging stories about international trade and interest rates. So what does the earnings picture say?
For the fourth quarter of 2018, companies in the S&P 500 Index, which represents the largest businesses in the United States, had respectable results. About two thirds of the companies had positive earnings surprises.
What’s more, earnings growth rates were in the double digits, and all sectors participated (source: FactSet). In other words, the earnings story helped to provide substance to support the early-year rally.
However, the market always looks ahead, as well, and there the picture is less bright. Market analysts tracked by FactSet, a data company, expect that earnings will decline in the first quarter and then grow again over the rest of the year. The economy picked up speed in 2018, and while it is difficult to sustain that same level of growth, the outlook calls for earnings and revenue to continue growing in 2019. Putnam’s viewpoint is that the economy is late in the expansion, and its teams are focused on businesses that they think can outperform in these conditions.
It’s important to note that if the rate of earnings growth remains positive in most quarters, with only minor setbacks, the absolute level of earnings should continue to grow and create opportunities for well-diversified equity portfolios.
The long and short
A long-term endeavor like investing requires setting both realistic goals and realistic expectations. It also means revisiting certain topics from time to time. Headlines and emotions can influence prices in the short run, but earnings tend to influence prices in the long run. Active analysis of companies to understand earnings trends and identify possible surprises can be a helpful ingredient in a strategy for investing in equities.