The analysts are cutting forecasts ahead of the fourth quarter reports
The money time of the fourth quarter report season is approaching, with most of the big reports (except the banks) still ahead. However, the feeling in light of the events of the last quarters is that the reports have become secondary in their impact on the markets compared to the macro factors, which are the ones that really drive the markets. One or another company can soar or (mainly) fall following the quarterly report, but the market as a whole reacts less to the reports themselves.
Meanwhile, analysts continue to cut forecasts across the length and breadth of the market. When divided into sectors – in nine sectors, the analysts lowered forecasts for earnings per share by up to 19.9% (the raw materials sector). Forecasts were raised in only two sectors – utilities and energy, and only by 2%. On average, the companies in the S&P are expected to present profits 4% lower than those of the fourth quarter of 2021, despite an expected increase in revenues of 3.8%, according to the research site Factset.
Even in a longer view, the analysts are not particularly optimistic. In the first two quarters of 2023, a decrease in profits compared to the corresponding quarter is expected despite the continued increase in revenues. The increase in profits will return, according to the forecasts, only in the third quarter of 2023.
Don’t be surprised if you often hear again that the companies “beat the forecasts”. The forecasts, mainly by the companies themselves, and subsequently by the analysts who are influenced by these forecasts in their assessments, are initially lower than what is really expected due to the fear of the market reaction. An upward “surprise” encourages investors in the stock, and a miss, of course, brings it down. Therefore it is better to “expect” at least and be surprised. Therefore, the companies that lowered the forecasts this time will do so to lower forecasts in advance. We note that in the third quarter in all sectors with the exception of services there was an average upward surprise in revenues. When the surprise becomes the new normal it’s not so much a surprise anymore.
Macro: Changing the investment environment after 40 years
Howard Marks has been investing in the markets for over 50 years. In 2022, his fortune was estimated at 2.2 billion dollars. “Octree Capital Management”, his investment company specializing in alternative investments, manages over 160 billion dollars, and is the world’s largest investor in distressed companies.
Marks published an article on the fund’s website presenting his insights from the latest developments in the markets, according to which we are witnessing one of the biggest changes in the markets since he began his investment career: “In my 53 years in the investment world, I have seen several economic cycles, pendulum swings, over-enthusiasm and panic, bubbles and crashes, But I remember two dramatic changes (sea changes). I think it is possible that today we are in the midst of the third.”
The first change – profit potential depending on the risk
When he began his investment career in 1969, bonds rated B were not considered investable, let alone BB and below. In the mid-1970s, Mikal Milkem and others changed this concept, when they developed the understanding that even low-rated bonds are worthy of investment given the interest that compensates for the risk. In 1978 Marks joined the trend and began investing in the “most dangerous companies in America” and generating cash in a “stable and safe” manner according to him. That is, the ability to invest in bonds of risky companies has been created as long as they compensate for this risk with adequate returns. The result – the bond market at risk which was estimated at 2 billion dollars when he started investing in it, is now worth 1.2 trillion.
This change led to another change. Until that time, the purchase of companies was done by large companies, those who could pay in cash or borrow enough money to make a purchase without damaging their investment rating. The ability to raise debt at high interest rates allowed smaller companies to expand through acquisitions, sometimes even of larger companies, through high leverage. This enabled the growth of the leveraged buyout industry and what is known as the private investment industry.
These changes brought a new mentality to the investment world. If until now the most important thing was to avoid risk, now the risk is measured according to the profit potential. The way of thinking about risk in relation to profit potential was critical in the development of new types of investments such as bonds of distressed companies, mortgage-backed securities, private loans, etc. It is not an exaggeration to say, according to Marks, that the current investment world is completely different from that of 50 years ago Thanks to this change, today it is impossible to think about investments other than in terms of risk versus chance. This is a dramatic change in the dominant investment philosophy.
The second change: a downward trend in interest rates
In the 1970s, an inflationary outbreak began that lasted for many years, and even reached a double-digit rate for several years. Ultimately this caused Governor Paul Volcker’s dramatic interest rate hike in 1980 to 20%. The brave (and controversial) move eventually brought inflation under control, which by the end of 1983 had returned to a level of 3.2%, as in 1972 before the inflationary outbreak.
This takeover made it possible to gradually lower interest rates to a high single-digit rate, where the interest rate remained for the rest of the 1980s. In the 1990s the interest rate had already reached a mid-single digit rate. The trend of lowering interest rates continued in the next millennium as well, culminating in zero interest rates for most of the second decade of the 2000s. The trend of a continuous decline in interest rates over decades is the second change Marx points to.
A combination of the two changes – the disappearance of fear and the pursuit of returns
The combination of these two changes – coordinated risk, profit potential and a continuous downward interest rate trend resulted in two results: a. A rebirth of investor optimism. B. Begin the pursuit of returns through aggressive investment tools. Between the years 1982 and 2022, the average annual return on the Snoopy index was 10.3% – one of the best periods in history, if not the best, for investors.
There were other factors that helped investors generate amazing returns for four whole decades. Among other things, strong and continuous growth in the United States, the amazing performance of the large companies, the progress of technology and productivity as well as the company management methods and the benefits of globalization. But in Marx’s opinion the most important factor is the consistent and continuous drop in interest rates. “It seems to me that a significant part of all the money that investors earned during this period was due to the tailwind created by a massive drop in interest rates… The impact of the drop in interest rates over the past four decades cannot be exaggerated.”
These trends peaked in the previous decade. Between the end of the 2008 crisis and the beginning of the Corona crisis – about 11 years – extremely low interest rates were recorded. The interest rate was cut to 0% at the end of 2008 and in addition a quantitative expansion was carried out. All this caused economic growth, an increase in company profits, and in any case increases in the markets almost non-stop for about a decade – the average annual increase between the peak of the 2008 crisis and the beginning of the epidemic was about 16%.
The trend continued into the third decade. The outbreak of the corona caused the Fed to loosen the reins even more with aggressive stimulus programs. After the initial crisis and the declines in March 2020, the markets rebounded in the next two years by over 100%. The risk-free return was zero, the fear of losses disappeared and the market was full of returns. All of this has caused increasing risk taking as fear has all but disappeared from the markets. The buyers wanted to buy and the property owners did not want to sell and the valuations only went up and up.
All that has changed in the past year. Inflation began to erupt in early 2021 as too much money chased too few goods and services. Consumers returned to consuming with the help of the government incentives before factories returned to full production. The Fed did not respond in time to the change because it saw inflation as a passing thing until it realized its mistake at the end of 2021.
In March 2022, the trend of raising interest rates began, which became one of the fastest in history, and the market reacted accordingly. The increase in interest rates created an investment alternative, rising yields and falling bond prices, the fear of losses replaced the desire for profit, an increase in the debt raising costs of the firms, a credit crunch for new purchases and all of this of course resulted in declines in the markets. The easy money disappeared from the market.
Is this a temporary situation? Probably not – and this is the third change we are in the middle of
According to Marks, inflation and interest will be the dominant factors in the investment climate for several years. Inflation will likely remain relatively high for some time. In his estimation, the Fed would like to see a positive real interest rate. Now it stands at 2.2%- (that is, inflation is higher than the Fed rate by 2.2%). Globalization will slow down or even decrease and lose its deflationary effect. In addition, there is still a balance sheet of over 8 trillion dollars to deal with. The Fed will let the bonds it purchased expire and not buy new ones, which will cause a decrease in liquidity in the market.
All this and more, will mean that interest rates in the coming years will stabilize at a rate of 2% to 4% and not 0% to 2% as they were for over a decade. That is, the expansionary policy will not return in the coming years. The new reality is of the highest inflation in the last 40 years and the highest interest rate in the last 13 years. This is the third substantial change in his lifetime as an investor.
The conclusion: changing the investment strategy
Marks ends the long article with the following lines: “If you are certain that market conditions will continue to be very different from what they have been for 13 years – and most of the last 40 years – the conclusion should be that the investment strategy that worked best during these time periods is no longer the one that will outperform in The following. This is the third fundamental change I’m talking about.”
In other words – taking risks is less profitable in a world of risk-free returns at a reasonable and much higher level than before. If in the last 40 years taking a high risk almost always resulted in high returns, and those who risked more were more successful, then now many of the risks will materialize and lead to painful losses. A more solid strategy will yield stable income over time.
Micro: a technological growth company – is it time?
The title of this section – Technological Growth Company – has become almost a dirty word in the last year. Marx’s market analysis on which we expanded also does not encourage investment in this direction.
The other side of the coin is that for several weeks now there has been a slightly different feeling in the markets, which has been reflected in the increases in recent weeks since the beginning of 2023. Are these false expectations? Are investors deluding themselves that inflation will calm down, that the Fed will change direction, that a recession will not occur in the end as Marx believes? Or are the optimists finally right after many months?
They will say that the current prices have really become attractive in the long term, especially in the growth companies that were cut in the last year. If you are on the optimistic side, you can carefully consider returning to investing part of the portfolio in growth companies, those that continued to show revenue growth at the same time as the share price fell. One of them is a friend
CERIDIAN HCM HOLDING INC
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– which is traded at a market value of 10.4 billion dollars.
What does the company do? This is a software company active mainly in the United States and Canada. Its main product is a platform in the field of human resources and salaries. and another product from the same field for small businesses. It sells its services directly to customers or through distribution channels. The company is considering expanding into other areas.
The company introduces the pincer movement we talked about earlier. Continued revenue growth and decline in market value. It lost almost 40% of its value in 2022, (but since the beginning of 2023 has already returned close to 10%), although it continues to grow every quarter at a double-digit annual rate, both in revenue and profit. In the third quarter, the company showed growth in almost all parameters: revenues grew by 24% compared to the corresponding quarter. EBITDA grew by 93% and adjusted earnings per share by 24%. Free cash flow grew by 65%. The company even made predictions for the future.
The risks: Let’s remember, however, that the uncoordinated bottom line is a losing company. that the value reflects a multiple of 10 on the revenues (!!), even after the recent declines, and in the event that the “mini-correction” of the last few weeks is only a respite, the stock still has a lot to go down, So this is a high risk investment for those who expect a change in direction in the markets.