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Factors Affecting Share Prices in the Stock Market: A Deep Dive into Earnings Correlation

Discover How Company Earnings Impact Share Prices and Learn Key Investing Insights from Top S&P 500 Stocks

Hello and welcome to this week’s Lockstep Investing Newsletter.

I’m excited about this week’s newsletter as we get to the core of what we should be focusing on as investors as we discuss the following:

  • Market Recap: Economic data points to a slowing economy, with the exception of Friday’s nonfarm payroll.

  • Highlights for the Week Ahead: It’s a busy week ahead as the Fed convenes to discuss interest rates. CPI and PPI data should make the Fed’s decision a little easier

  • Factors Affecting Share Prices in the Stock Market: Peter Lynch famously stated that a stock’s share price correlates with the company’s long-term earnings. We take a deep dive into earnings and share price correlation to see if the statement is accurate and how it influences our investment decisions.

  • Lesson Learned: Innoviva’s CEO gave an informative presentation yesterday. Given our recent discussion on the company, we unpack the new information we have learned.

Ready?

Let’s dive in!

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MARKET RECAP

Market Performance for Week 23

Last week, I mentioned there wasn’t much economic news worth tracking from a long-term perspective. However, plenty was happening to influence the market’s short-term outlook as it reached new record highs, with the S&P 500 up +1.3% for the week.

Economic News

May’s ISM Manufacturing PMI

On Monday, the Institute for Supply Management (ISM) released its Manufacturing PMI for May. This survey of purchasing managers at over 300 manufacturing companies in the US showed a PMI of 48.7%, down from April’s 49.2%. A PMI below 50 indicates a contracting economy, and the market viewed this as a positive sign that inflation might cool due to the slowdown.

April’s JOLTS Report

Tuesday saw the release of April’s Job Openings and Labor Turnover Survey (JOLTS). The report showed 8.059 million job openings, below the expected 8.355 million, with March’s figures revised lower. This weaker labor data was seen as another positive in the Federal Reserve’s fight against inflation.

May’s ADP National Employment Report

On Wednesday, the ADP National Employment Report indicated that private payrolls increased by 152,000 in May, well below the consensus of 194,000, with April’s numbers revised downward. Again, this suggested a slowing labor market, which should help reduce inflationary pressures.

May’s Nonfarm Payrolls

The week’s big release was on Friday, as May’s nonfarm payrolls report suggested 272,000 jobs added, significantly surpassing the 185,000 estimate and last May’s 232,000 job adds. However, the unemployment rate rose to 4.0% from April’s 3.9%, providing a mixed picture.

This report bears more weight than Wednesday’s ADP report, and the market reacted negatively.

What Does All The Data Mean?

The US has been battling persistent inflation, with the Federal Reserve raising interest rates to counter it. A strong economy and labor market have kept inflation high.

Last week’s data, except for Friday’s nonfarm payroll report, indicated a slowing economy and labor market, which the market interpreted as positive for reducing inflation and hopefully enticing the Fed to cut rates.

Looking Ahead

This week is crucial, with May’s Consumer Price Index (CPI) and Producer Price Index (PPI) out on Wednesday and Thursday, respectively. These inflation measures will influence the Fed’s decisions as it convenes today and tomorrow to deliberate on interest rates.

While there is close to 0% expectation of a rate cut this month, The market’s confidence in a September rate cut continues to seesaw as economic data continues to roll in.

The Market’s Value

Despite the noisy economic data, the market continues to hit all-time highs. The S&P 500 is up over +12% year-to-date, and the Nasdaq Composite has risen over 14%.

As market prices climb, so do valuations, and the S&P 500’s current P/E ratio is 27.8, higher than the 50-year average of 20.5.

Valuation Insights

A few big tech names have significantly influenced the S&P 500’s performance, with the top six constituents boasting a weighted P/E of 43x.

Here’s the breakdown:

Company

Ticker

P/E

Microsoft

MSFT

36.8

Apple

APPL

30.3

Nvidia

NVDA

70.7

Amazon

AMZN

51.9

Meta Platforms

META

28.5

Alphabet

GOOG

27.1

Nvidia’s P/E suggests it would take 70.7 years to earn back your investment through current earnings, highlighting the high growth expectations priced into the stock.

Sustainable growth is crucial for maintaining high valuations, so even if NVDA’s near-term earnings meet expectations, it needs to be able to retain them for the long term, not just a quarter or two.

So, while the market doesn’t appear to be in bubble territory, a few high valuations make me cautious.

MARKET HIGHLIGHTS FOR WEEK AHEAD

May CPI

  • When: Wednesday, 12th of June 2024

  • Where: Bureau of Labor Statistics

  • Why It Matters: The Consumer Price Index (CPI) is an important measure of inflation. Both the Federal Reserve and the market look to it to better understand inflation’s trajectory and as an indicator of when the Fed might start lowering rates. Expectations are for May 2024 CPI of 3.36% versus May 2023. The market will welcome anything significantly below.

Fed’s Interest Rate Decision

May PPI

  • When: Thursday, 13th of June 2024

  • Where: Bureau of Labor Statistics

  • Why It Matters: Similar to the CPI, the Producer Price Index (PPI) is a measure of inflation. Because it is at the wholesale level, the Fed places less weight on it; however, it is still important.

INVESTING CHRONICLES

Investing is hard and the best way to improve your own investing is through others. So, under “Investing Chronicles”, I’ll share my learnings from my 18+ years in the stock markets.

There is a 100% correlation with what happens to a company’s earnings over several years and what happens to the stock (price)

The statement above comes from a 1993 interview with Charlie Rose, which we discussed last week in “How to Value a Business Based on Future Earnings

In essence, Lynch is saying that if a company’s earnings perform well over a sustained period, its share price will do as well, regardless of market and political noise.

That is a bold statement!

If true, it simplifies our approach as investors because it means all we have to focus on is the company and its fundamentals, leaving aside short-term share price performance and economic and market commentary.

But is this true? Let’s explore.

The Correlation Between Earnings and A Company’s Share Price

What is Correlation?

Correlation simply means there is a relationship between two or more variables. For example, egg prices are correlated with the supply of eggs—if there is a shortage of eggs, prices will increase.

How to Measure Correlation

Correlation is measured on a scale from -1.0 to 1.0:

  • A correlation of 1 implies a perfect positive correlation, meaning both variables move perfectly together.

  • A correlation of -1 implies a perfect negative correlation, meaning as one variable moves up, the other moves down.

  • A correlation of 0 means there is no relationship between the two variables.

In our case, we are looking for a strong positive correlation. Anything above 0.9 is considered exceptionally strong.

You don’t need to worry about the mathematics behind it; I’ll do the calculations for you!

Correlation in Our Investing

Our goal is to see if there is a correlation between earnings and share prices. If a company’s earnings increase, does the share price also increase?

We’ll examine a company’s revenue, operating income (or Earnings Before Interest and Tax, EBIT), and net income growth vs. the share price and account for dividends, as they reduce the share price by the same amount.

Microsoft Case Study

Let’s start with the largest company by market cap in the S&P 500, Microsoft (MSFT). We will look at the company’s revenue per share, operating income per share, and net income per share from 2000 to 2023 and compare the growth to the company’s share price over the same period using the closing share price for its financial year-end.

As you can see from the graph, revenue, operating income (EBIT), and net income have all increased significantly from 2000 to 2023, while the share price has also increased, although it lagged slightly. This lag is expected as earnings are not released immediately, so the share price needs time to respond.

More importantly, the correlation coefficients are as follows:

  • Revenue: 0.93

  • Operating Income: 0.96

  • Net Income: 0.96

Any correlation above 0.9 is incredibly strong, indicating that as Microsoft’s earnings increase, its share price follows almost perfectly.

Broader Analysis

We need more than one sample for a good study.

Here are the correlations for the top 6 stocks in the S&P 500:

Company

Ticker

Revenue

EBIT

Net Income

Microsoft

MSFT

0.94

0.97

0.96

Apple

AAPL

0.96

0.95

0.96

Nvidia

NVDA

0.99

0.98

0.98

Amazon

AMZN

0.93

0.95

0.90

Meta Platforms

META

0.80

0.93

0.93

Alphabet

GOOG

0.94

0.94

0.95

All companies show a very high correlation between earnings metrics and share price.

This suggests that focusing on a company’s fundamentals is vital for long-term investment success. Most interestingly, operating income, on average, correlates with the share price the most, meaning it should be our main concern.

Conclusion

Peter Lynch was onto something when he emphasized focusing on a company’s earnings.

Investors should concentrate on the company’s economic growth rather than short-term market fluctuations, the broader economy or political landscapes. A company growing its revenue and maintaining high operating margins will likely see its share price follow.

If the share price doesn’t appreciate, it may indicate a buying opportunity, as the market may be missing out on an excellent investment.

LESSONS LEARNED

There is no faster way to learn about investing than through the Greats. Here, I share lessons from the best investors and thinkers.

Innoviva Update

Last week, we looked at the investment case of Innoviva (INVA). If you missed it, you can read it here.

Yesterday, the company gave a presentation at the Goldman Sachs Healthcare Conference. The presentation provided valuable information, so I highly recommend listening if you follow the company.

Here are the highlights that stood out for me from the presentation:

Royalties Revenue

  • The CEO of INVA expects these royalties to be stable and durable for “years and years.”

Xacduro

  • Expected to be a significant revenue generator.

  • Zai-lab expects sales of over $500 million per year in their territories. Innoviva will earn royalties from Zai-lab’s sales similar to its other royalty revenue streams.

Zoliflodacin

  • There are 1 million cases annually in the US and over 80 million globally – “This is just a huge opportunity.”

  • “It could be a $500 million per year product in the US alone.”

NOTE: INVA only earns revenue from sales in US and other developed markets for this product.

Other Insights

The analyst interviewing INVA’s CEO remains skeptical about the company’s ability to commercialize its antibiotic products, as many other companies have failed to do so.

This is both a risk to the company and a reason for the opportunity - If Innoviva fails, it will only have its royalty stream to fall back on. However, the market is currently discounting the products on the Innoviva platform. If Innoviva succeeds, it should perform very well.

Conclusion

Last week, I provided a rough UPSIDE calculation of around $32.40 per share versus the current price of around $15.94. Based on the additional information from the presentation, it is easy to see a well-over $40 per share upside.

Disclaimer: The content in this newsletter is provided for informational purposes only. It is essential to conduct your own research before making any investment decisions.

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