Below is a review of Eagle Ridge’s Investment Committee discussion
Despite the COVID-19 environment in which we are all living, many large US companies have greatly exceeded quarterly earnings expectations. Several of our holdings beat analyst estimates by wide margins, including core portfolio positions Alphabet (GOOGL), Microsoft (MSFT), O’Reilly (ORLY) and Stryker (SYK).
We focus on the long-term and never get too caught up in a company’s quarterly estimates. At our weekly Investment Committee meeting, we took the time to review this trend and discussed what, if anything, we could glean from it. The following paragraphs provide a summary of the conversation and insight into our investment process.
Right off the bat, David Tillson, founder of Eagle Ridge, pointed out “analysts are flying blind” with a multitude of companies foregoing guidance. Combining that with the natural tendency to guide low in order to allow companies to more easily beat estimates, the blow out earnings were easily explained.
David Laidlaw, our managing partner, agreed, pointing out that “everyone in the estimates game is better served when companies beat expectations.” This allows companies to look good and is more likely to drive stock prices up. Laidlaw also noted the messaging that went with earnings reports. He pointed out that MSFT beat revenue estimates by $1.4B and the headlines read that it was driven by their Cloud revenue being about $200M more than estimated. This is true and reads well, as Cloud revenue is expected to continue to grow, but the PC revenue was $600M more than expected. However, PC growth is less driven by a secular trend and more one-time in nature, probably due to the increase in work from home. Therefore, it doesn’t feed as well into the Microsoft growth narrative that can push the stock higher.
After initial thoughts, it appeared we were generally unimpressed with companies beating estimates, and the entire process of estimating earnings was suspect due to the incentives for those involved.
Lynn Najman, the newest member of our investment team, noted that we were overlooking key points. For example, how successful companies were in pivoting to the current environment, such as working and shopping from home, and analysts “missed how quickly companies could adjust to this fundamental change.”
Ron Sages, a portfolio manager with an extensive academic research background, had us step back for a moment and remember “the tremendous amount of doom and gloom” early in the pandemic. This reinforced that significantly reducing estimates was valid.
Michael Oliver, Eagle Ridge’s newest partner, agreed, noting that retailers had been preparing for years to increase online sales, and this effort has gone into overdrive. This was partially to defend against Amazon but also simply because online sales were growing faster than brick and mortar. Most retailers now provide an omnichannel shopping experience, where it doesn’t matter whether the consumer is shopping from their phone, desktop or the store. The important part is a seamless customer experience that gets them what they want. Tractor Supply (TSCO) has focused on this strategy. Other companies are streamlining operations and going directly to the consumer- Nike (NKE) being a great example with its popular mobile apps.
Tillson pointed out that management is paid to fix problems, and while COVID-19 presented a massive problem, we shouldn’t be too impressed. At Eagle Ridge, we’ve always strived to understand how the managers of our underlying holdings allocate capital. As John Knox, co-founder of Eagle Ridge, noted, “companies are dynamic and should always be thinking strategically.” Part of our job is to ensure that they are allocating the capital properly to drive long-term value creation. These allocation decisions include, but are not limited to, stock buybacks, dividend payments and acquisitions.
Capital allocation has come front and center during the pandemic. Some companies, such as GOOGL, have cut back hiring in response to slowing sales. Others, such as Disney (DIS) and the TJX Companies (TJX), have stopped dividend payments. Cutting back during the pandemic was somewhat obvious, and now companies need to be smart going forward. Decisions by DIS and TJX show an obvious contrast. Instead of reinstating a dividend, Disney is choosing to further invest in their direct-to-consumer offerings, e.g., Disney+. TJX, on the other hand, reinstated its dividend with an increase. We believe both companies are making smart decisions based on their respective industry and business model.
As our discussion wound down, it became clear the Investment Committee shared a few strong viewpoints. A properly managed company should be able to react quickly to a problem, even one as extreme as a pandemic. Companies did an exceptional job adapting their business models to adjust to the new normal. We did not conclude that these were contradictory thoughts. Finally, we reiterated our most important consideration when evaluating a company: earnings are nice, but can the company generate cash? This is a foundational point we often come back to when researching companies.
Returning to the question we posed in the title of this blog, “Should We Care?”, the answer is a resounding “No”. We don’t care that companies beat their quarterly earnings estimates. We care that they continue to think strategically and generate cash.