With market uncertainty and volatility at an all time high, the market isn’t what it was a few short months ago. It’s become challenging at best for investors to evaluate companies to invest in based on underlying fundamentals of the business, such as its earnings. What has played out over the last few months is a stock market that has been subject to whipsawing prices based on news headlines, political uncertainty and the daily whims of market sentiment. Some stocks are having unexplainable plunges or surges in price.
One company has stepped in to provide a solution by creating an investment product that gives funds and portfolio managers the ability to invest in isolated value drivers of a company such as revenue or net profits without exposure to other unforeseen variables and market forces. Termed “earnings derivatives”, they were created by BLX Global to give institutional investors access to a more stable strategy for forecasting and investing based on corporate earnings.
Where it gets more interesting is that BLX created their own market indices based off of their earnings derivatives which can shine more light into how corporate earnings overall are performing for a given industry or sector. This can give us a more surgical view into exactly how companies are performing and thus how the economy is performing, without the hype of wild stock market swings. We sat down with BLX Global’s founder, Jacob Mohs, to get his insights on what the Earnings Derivatives indexes can tell us about where the economy is headed.
GD: What is currently the biggest problem facing corporate earnings and asset prices?
Jacob Mohs: The number one problem for investors is that there is no such thing as consensus earnings anymore. A lot of investors had become accustomed to management basically guiding them to a correct forecast each quarter. But Covid-19 has changed all that. Most major companies have suspended long term earnings guidance.
Sell side analysts have been scrambling to adjust their forecasts, but the sell side earnings season process wasn’t designed for this environment. There is no precedent on which to model earnings for the rest of this year. The old tools for trading earnings season don’t work anymore.
Hedge funds are sourcing new alternative data sets to get an edge. Understanding how Covid-19 impacts companies requires a more creative and innovative research approach. There is a wider range of possible outcomes than before.
There is also the factor of government intervention to support the economy. It will have an uneven impact across different industries, and across different parts of capital markets. Investors need to factor all of this into their decision making process if they want to predict where asset prices are going.
Can you describe what an Earnings Derivative is?
Earnings derivatives are a tool for investing directly in company and industry earnings streams. This is implemented as a cash-settled option, where the strike “price” is based on a target earnings level, with expiration dates that coincide with the release of company earnings reports. Investors can go long or short company earnings for a particular quarter, with profits on their position directly tied to how much a company beats or misses earnings.
Stock price can be broken down into the earnings a company generates and a multiple on that earnings. Earnings reflect actual company performance. Multiples reflect market sentiment about future changes. Earnings derivatives turn earnings into their own investable asset class. This allows you to make investment decisions based directly on business fundamentals, rather than changes in stock market sentiment. You can also use earnings derivatives to hedge short term earnings uncertainty and mitigate volatility of stock positions. We have three patents pending on the unique methodology behind earnings derivatives. As this market develops it will be the biggest change to equity investing since the invention of stock options in the 17th century.
How does that tie into the market indexes created by BLX?
Earnings Power Indexing extends the idea of earnings derivatives to sectors and themes. We developed this unique method of indexing that can track rolling trailing twelve month earnings and revenue of different industries. For example the FAANG Revenue Index directly tracks changes in combined aggregate revenue of Facebook, Amazon, Apple, Netflix and Google. The Domestic Airlines Revenue index does the same for the airline industry. Options on these indexes can be used to hedge industry downturns, or express macro views at the industry level. It’s all about separating out company fundamentals as a tradable asset.
What impact do you believe most companies withdrawing their earnings guidance will have on how investment decisions are made?
Without management guidance, analysts will need to do a lot more research to get an edge in predicting earnings. Price discovery is going to be a messy, volatile process in the absence of clear consensus. Investors need to be ready to handle more surprises coming from company announcements, and changes in government policy. One way to do that is to hedge with derivatives.
How has the performance of your own indexes guided your outlook for the markets for the rest of 2020?
Our indexes have shown the great divergence in the economy as a result of Covid-19. Most sectors are decimated, but some can thrive in a world of social distancing. In some ways Covid-19 has accelerated existing trends towards a more online world.
The FAANG Revenue Index and FAANG Earnings Index have been going consistently up since 2014, and analysts expect that to continue. The FAANG companies- Facebook, Amazon, Apple, Netflix and Google generally benefit from nationwide stay at home orders. However, we still haven’t seen the full impact that changing consumer habits will have on online advertising.
Banks have had middling earnings growth the last few years. They were continuing to generate new business through the beginning of this year, but when Covid-19 hit they took a big bath in this latest quarter, writing down a lot of loan losses that they anticipate will occur. That severely impacted earnings. The Select Bank Revenue index only dropped around 2%, but the Select Bank Earnings index dropped 15% after the latest quarter’s earnings.
Airlines took a hit in the second half of Q1, but analysts are expecting them to fall off a cliff in the next two quarters. The Domestic Airlines Revenue index dropped about 4% after the latest quarter. Based on median analyst estimates for the index components, it is expected to drop another 20% in Q2. Beyond that there is no visibility. It all depends on how long coronavirus impacts business travel and vacation plans. Even if airlines get government help to avoid bankruptcy, it won’t necessarily boost their revenues, unless society rapidly opens back up. If there is a second wave of infections and we’re forced to have a second lockdown, it will directly impact airline revenue. The Domestic Airlines Revenue Index is going to be a great tool for hedging the risk of a coronavirus second wave.
How much of the current earnings picture for 2020 or even 20201 do you think is already priced into equities?
Second quarter earnings are going to be a lot sketchier than first quarter’s earnings. Third quarter earnings will be potentially worse. Stock prices imply that a lot of investors expect a quick snap back to normal. I’m not so sure that will be what happens. This latest batch of earnings really only had one month of the Covid driven demand shock. In the second quarter we’ll see the impact of an unprecedented lockdown. In the third quarter we’ll start to see the impact of habit changes. Eventually we’ll get through this, but things won’t go back to normal all at once. Different states will have different rules. People will react differently when they are free again. Also on the supply side- we’ll really only start to see the impact of supply chain and inventory problems later this year. If there isn’t a quick snap back in earnings, Fed intervention that is even more aggressive than what we’ve seen will be needed to support equities at current levels.
Do you believe investors can make investment decisions based on fundamentals in the current environment given how COVID-19 news is driving prices
Investors need to take all factors into account when making decisions. Stock prices will overreact in both directions to every bit of Covid-19 news. Eventually we’ll get a new vaccine, but when it does there will be the logistics of mass production and distribution to worry about. Aggressive monetary and fiscal policy to fight against the recession will boost asset prices, but it will help some industries more than others.
At the micro level, resiliency will matter more than efficiency. You need to be sure that companies you invest in can handle extended shutdowns. Companies that have been hiding behind financial engineering are going to get exposed. Organic earnings growth is going to be in again.
