Markets do a good job of amalgamating the expectations of investors. More art than science, the picture that results can resemble abstract expressionism rather than figurative verisimilitude. It is hard to know which factors matter most.
One trend that markets do follow is the direction and pace of earnings growth for listed companies. For good reasons: first, share prices reflect the present worth of the stream of future profits. Profit trends also influence the amount of cash available for dividends. Finally, a company’s share valuation relative to its earnings per share provides a measure of the market’s optimism or pessimism about the company’s prospects.
Investors are thus highly sensitive to news about corporate earnings, both from seasonal reporting and any management discussions. The reaction to bad or good surprises on earnings can be extreme.
Consider the experience of THG, formerly known as The Hut Group, a conglomerate of ecommerce brands which warned about lower than expected profits on Tuesday. Its share price collapsed over a fifth on the day. On a price chart that might look trivial given that THG has already given up nearly 90 per cent of its value from its September 2020 flotation.
Having said this, share prices do not always move in lockstep with earnings estimates. The market may not agree with forecasts from the brokerage analysts who follow companies. Over the four months after its listing, THG’s stock price climbed 60 per cent at a time when after-tax earnings, on which dividends depend, were more hope than reality.
Although analysts overall remained optimistic, regularly increasing their earnings per share forecasts, concerns about THG’s corporate governance weighed on its market value. As the growth promised for a newfangled technology stock dissipated, investors could see only an overpriced collection of ecommerce sites.
The market’s collective nose sniffed trouble and eventually analysts’ assumed profit trend went into reverse. When the pandemic ended, the previous boom in online shopping by homebound web surfers fizzled out.
Occasionally the share price impact from negative news can be counterintuitive. Sentiment will play a part in how bad tidings are received. Luxury retailers Richemont of Switzerland and Britain’s Burberry on Wednesday both offered bad news about their previous quarter’s sales in China, down by over a fifth for both.
As noted in a recent Lex Populi, purveyors of luxury goods have received plenty of sales impetus from increasingly wealthy consumers in Asia. For both companies China represents around a quarter of their top line. Neither has yet reported full-year results.
However, their stock prices did relatively well on the day, especially London-listed Burberry. Its management’s optimism on China’s economy, given the long-awaited end to its zero-Covid policy, was well received by investors.
All this suggests that while the direction and pace of earnings growth matters for any company’s share price, equally important is the extent to which the market has anticipated the news. THG clearly has few fans but, even so, bad news was just that for its share price. However, investors wear fashionably rose-tinted spectacles when assessing the prospects of luxury goods makers.
Smaller gold sacks for the bankers
Barometer readings on a company’s growth potential are not always directly related to earnings.
If many of us struggle with dry January, Wall Street investment bankers saw their bonuses evaporate last year as the deal flow withered. Those at Goldman Sachs would have more than that to blame. Despite its towering reputation internationally, an underlying erosion of earnings from its relatively new consumer finance unit could no longer be offset by a strong showing from the rest of the bank.
Chief executive David Solomon had championed the plain-vanilla, consumer bank branded as Marcus, even though it was not a project of his making. He hoped Marcus would diversify the bank’s revenues and create a steadier income stream, less dependent on the vagaries of the dealmaking cycles.
One US bank which has managed this transition well since the global financial crisis is Morgan Stanley. Its strategy of aggressively expanding its wealth management business paid off, as the rich became ever richer, while also generating recurrent fee income.
By 2021, wealth management alone accounted for nearly a third of after-tax profits for Morgan Stanley, triple the proportion of 2010, according to S&P Capital IQ. Though Goldman has a well-developed asset and wealth management business, it relies much more on its volatile investment banking unit.
Investors took note and have priced their preference into Morgan Stanley’s shares, in this case via its price to book value, a more typical valuation measure for banks. Book value, also known as shareholders’ equity, refers to the difference between total assets and liabilities on the balance sheet.
At the beginning of 2020, both Morgan Stanley and Goldman Sachs had similar ratios. Fast forward a few years and the former has opened up a 60 per cent premium, at 1.8 times book value, over Goldman’s price to book ratio.
Without the cover of its powerful investment banking franchise, the Goldman consumer bank experiment has been found wanting. It has weakened profitability, as reflected in its full-year results released on Tuesday. Goldman’s net profit divided by its book value — its return on equity — at a measly 4.4 per cent was less than half that of its rival in the fourth quarter.
A lot can happen in a year. But without a serious rebound in its dealmaking, Goldman Sachs shares will continue wallowing close to its book value for some time to come.
Lex Populi is an FT Money column from Lex, the FT’s daily commentary service on global capital. Lex Populi aims to offer fresh insights to seasoned private investors while demystifying financial analysis for newcomers. Lexfeedback@ft.com