You can still friend me, but I won’t risk an earnings miss

July 27, 2018 Edward Golding

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I get asked lots of questions from friends and family about stocks and investing in certain companies.

Typically, they want to know my opinion about market darlings whose stellar sales and earnings growth are reflected in high share prices. In the last year, I’ve fielded questions about Canadian marijuana companies like Canopy Growth, U.S. tech companies like Amazon and Facebook, and emerging markets companies such as Alibaba and Tencent, to name a few. 

I’m always happy to share my thoughts, but before I say too much, I always want to know one important thing: “How much do you have allocated to that company within your total portfolio?”

Friends don’t let friends over-buy Facebook

It can be tempting to load up on stocks that are going up at exponential rates. Over the past twelve months, many stocks have generated headlines for their exceptional returns: in local currency, Amazon is up 79.2%, Netflix 94.1%, Salesforce.com 64.3%, Canopy Growth 266.9%, Shopify 88.5%, Alibaba 30.0% and Tencent 26.2%. 

And then there was Facebook.

After markets closed on Wednesday, July 25th, Facebook reported its second quarter earnings. To a casual observer, the numbers looked strong. Year over year, revenue was up 42% to $13.23 billion, earnings per share was up 32% to $1.74, monthly active users were up 11% to 2.23 billion, and daily active users rose 11% to 1.47 billion. 

This level of growth is matched by very few in corporate America, yet the stock is down almost 20% wiping out nearly $150 billion in market value! How can this be?

It’s all about expectations of future revenue growth

The answer is that after years of performing better than analysts expected, Facebook suddenly didn’t. The company’s reported financials and user activity did not meet analysts’ expectations. It also pointed to lower revenue growth in the future—forward-looking guidance is critical to stock performance for high growth companies. 

Even though Facebook’s earnings per share exceeded analysts’ expectations, revenue of $13.23 billion was lower than expectations of $13.3 billion, monthly active users of 2.23 billion was lower than expectations of 2.25 billion, and daily active users of 1.47 billion was lower than expectations of 1.48 billion.

Also, Facebook warned its revenue growth rates are expected to decline by “high single digit” percentages in the coming quarters.

Missing expectations can have harsh consequences

Facebook’s miss on revenue and user activity appears small, not overly material and surely not worthy of a 18.96% wipe out of investor equity. But that’s precisely how much the stock dropped by the time markets closed on Thursday, July 26th.

For all its short-term imperfections, the stock market looks to the future. A company valuation is based on forward projection of many metrics including sales, earnings, profitability and, in the case of Facebook, user activity. 

Before its latest quarterly release, Facebook commanded a high valuation, trading at almost 30 times 2018 expected earnings. That’s a significant premium relative to the S&P 500 benchmark, trading at almost 18 times 2018 expected earnings.

To justify this lofty valuation, growth needed to exceed analyst expectations. When the company failed to do this, analysts lowered future projections of revenue, earnings and user activity, leading to a lower valuation. Even with the 20% haircut, Facebook is still trading at 24 times 2018 expected earnings.

Facebook friends from the start, with a 37% annualized return

We have been invested in Facebook in the MD American Growth Fund and MDPIM U.S. Equity Pool since the company went public on May 18, 2012. We believed the growth prospects from its strategy into building out its mobile advertising platform to be well worth the lofty valuations the company commanded at the time. Our investment has paid off, with Facebook stock up an annualized 37% since our first investment.

However, the risk of investing in Facebook can be material, so we have kept our average exposure since May of 2012 to 1.70% in the MD American Growth Fund and just 0.97% for the MDPIM U.S. Equity Pool.

Over the past five years, investors have generously rewarded companies that posted high rates of sales growth in a slow growth economic environment. If you didn’t allocate at least a portion of your portfolio to high growth companies, it would have been hard to match benchmark returns. 

In the long run, studies conclude that earnings growth is a strong driver of equity returns. But in the short run, as we’ve seen with Facebook, analyst expectations can play a significant role in equity performance, especially for high growth stocks. 

So, when I question family and friends on how much of any one stock they have allocated within their portfolio, a blank stare in response tells me they have no idea.

A comprehensive portfolio approach is critical to ensuring that all risks are known and calibrated to an appropriate level. 

That means ensuring that high growth investments in still-great companies like Facebook are embedded within a well-diversified portfolio—or else earnings misses can lead to financial goal misses.

If you genuinely don’t know how much Facebook takes up in your portfolio, it’s worth talking to your advisor to find out.

 

About the Author

Edward Golding

Edward Golding, CFA, MBA, is an Assistant Vice President with the Investment Management and Strategy team at MD Financial Management. He oversees the Canadian, Dividend and U.S. equity mutual funds and investment pools at the firm.

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