Earnings season for the second quarter of 2019 is fully underway, meaning that hundreds of large U.S. companies are in the process of reporting their performance over the past 3 months.
Last week, there were reports from all the major banks, a variety of industrial companies, and some large tech stocks. Despite decent results overall, the S&P 500 (which the C Fund tracks) dipped by over 1% last week, which puts it back under the 3,000 milestone. Next week there will be dozens of more earnings reports. This article takes a look at some notable reports that have big impacts on the C Fund.
All Big Banks Beat Estimates
The top ten largest U.S. banks ranked by asset size all reported earnings that surpassed analyst estimates. Estimates are usually conservative so that companies mildly beat them, however, 100% of the big banks beat earnings this season compared to the normal rate of beats which is around 70%.
J.P. Morgan, the largest bank and the seventh largest company in the C Fund (accounting for about 1.5% of the total fund assets), was one of the biggest achievers as it outperformed estimates by 13%.
However, most of these bank gains were driven by share repurchases and all of the banks reported declining net interest margins, which is the spread between the interest they earn on their assets (such as mortgages, credit cards, and other loans) and the interest rate they pay on their liabilities (such as deposits). The flattened and inverted yield curve is pressuring bank profit margins, and consensus growth expectations over the next year are not very high.
Netflix and Streaming Competition
Netflix stock, considered part of the prestigious “FAANG” group of high-growth tech stocks, fell by 15% last week, including drop of more than 10% the day after it released its earnings results. Netflix was expected to add 5 million new global subscribers but reported that it added only about half of that number. Additionally, they reported a rare decline of U.S. subscribers.
The competition in the streaming industry is heating up, with Disney set to launch its Disney+ streaming service later this year, and AT&T set to launch HBO Max early next year. Disney+ will include Disney Animation Studios, Pixar, Star Wars, Marvel, and other content. HBO Max will include HBO content as well as WarnerMedia content thanks to AT&T’s recent acquisition of that company.
All of this puts pressure on Netflix, and Netflix reported that they saw declines in their subscriber numbers especially in areas where they have been raising prices. Currently, Netflix is free cash flow negative, and has been fueling content production by issuing junk bonds. A reduction in its growth story puts pressure on the stock’s high valuation and debt-driven content spending strategy.
Over the past several years, the FAANG group consisting of Facebook, Apple, Amazon, Netflix, and Google (now Alphabet) has been responsible for pushing the S&P 500 (and the C Fund) to new highs, but their performance in 2019 has been mixed. Netflix, Apple, and Facebook are still well below their 2018 highs this year, and Amazon and Alphabet have just barely touched their 2018 highs.
Microsoft Takes the Crown
Microsoft is now the largest company in the C Fund, representing over 4% of the 500-company fund. It is currently the only publicly-traded company in the world with a market capitalization over $1 trillion, although Amazon and Apple are both over $900 million.
Microsoft reported strong quarterly results last week, and in particular their Azure cloud platform continues to shine, with 64% year-over-year revenue growth. Microsoft has been growing mainly from the enterprise data center side rather than the consumer side in recent years.
Many high-quality stocks like Microsoft, however, are highly valued, which could dampen future stock performance. On this chart below, for example, the black line represents Microsoft’s actual stock price and the blue line represents what its stock price would be if its price-to-earnings ratio was at its average over the past 20 years. The stock price has grown a lot more quickly in recent years than the company’s actual fundamentals such as earnings and dividends.
This is the case for many stocks in the C Fund and S Fund. Many lower-quality stocks appear cheap, while most of the higher-quality names are already trading at higher-than-normal valuations, which may make it harder for them to perform as well over the next 3-5 years.