Pre-Earnings Positioning Is Key

Yesterday afternoon featured three potentially significant market-moving events.  The first was the FOMC meeting, which turned out to be a relative non-event.  The committee kept rates unchanged despite two dissents, and Chair Warsh’s press conference lacked fireworks.  Markets finished the session roughly where they were before the decision.  The fireworks came after the close when Microsoft (MSFT) and Alphabet (GOOGL) (GOOGL, GOOG) reported.  Investors initially liked the former but immediately hated the latter.  The reactions tell us much about investor thinking and positioning.

For several months we have been insisting that a company beating its EPS and revenue projections was merely a necessary condition for a post-earnings rally, not a sufficient one.  In an environment where it has become routine for 80% (or more) of major companies to beat EPS estimates, that is a requirement, but no grounds for excitement.  Thus, GOOGL’s huge EPS miss – $2.12 vs. $3.33 consensus – was immediate grounds for disappointment.  In this case, cloud revenues were up thanks to AI, but search revenues were not.  The implication is that artificial intelligence and all the spending it requires is eating into GOOGL’s core revenue center.  Furthermore, while capital expenditures of $51.4 billion were less than the $57 bn estimate, but free cash flow was nonetheless negative $9 bn, with next year projected to cost even more.  Put it all together, and it’s clear why investors are souring on Alphabet today.

Contrast that with MSFT.  Earnings and revenues were better than expected, with EPS of $4.89, above the $4.73 consensus.  Its Azure cloud business grew revenues by 48%, and the company projects that rate of growth to continue.  MSFT’s capital expenditure of $45.2 bn was enormous and 30% higher than last year’s, yet lower than expected.  The company is clearly trying to maintain positive cash flow.  That figure came in at $18.5 bn, down from last year’s $25.7 bn, but above the $7.99 bn that analysts expected.  Investors initially liked what they heard, and the stock rallied in aftermarket trading.

Not so fast, though!  MSFT is trading lower today.  First, we saw some of the initial enthusiasm fade simply for lack of follow-through.  Then, this morning, we learned that the company will be selling $25 bn in its first bond offering since 2017.  The cash flow discipline is coming at a cost.

It is important to recognize that positioning, particularly by institutional investors, is playing a significant role in a stock’s post-earnings reaction.  If those investors are underweighted in a given stock and it posts excellent results, we see them rush back into the name.  This occurred in a wide array of software stocks last quarter.  Salesforce (CRM) was one example.

That was the case with MSFT last quarter.  It had fallen out of favor with institutional investors earlier this year, so when it posted surprisingly good results, investors flocked back to the name.  However, by the time this quarter’s results rolled around, those investors had built their positions back to market weight or above. 

Thus, even a solid quarter was not sufficient to further induce institutional buying in a significant way.  We’ve seen this before in names like Micron (MU) and Nvidia (NVDA), where those stocks failed to respond significantly, or even positively, despite what appeared to be a blowout quarter with upped guidance. 

The flipside of that is quite problematic, though.  If those investors are fully invested in a company, such as GOOGL, the negative reaction is sharp and swift.  If institutions feel compelled to exit a name quickly, there is not a huge pool of willing investors of similar size to step into the breach. 

The risks surrounding earnings have become asymmetrical, with the relative risk determined to a large extent by investor positioning.  If a name is out of favor before earnings, the risk is predominantly to the upside.  The market is already expecting disappointment – that’s why the stock has presumably sunk beforehand – and this is ripe for an enthusiastic response to good news.  If, on the other hand, a stock is widely owned and the investment thesis is well-disclosed and clearly embraced by investors, the greater risk is to the downside.  Ask yourself: Was anyone unaware of the investment thesis for MSFT, GOOGL, or for that matter, NVDA or MU, before today?   If the answer is “no”, then be wary of a tepid positive reaction and an ornery negative one.