In recent years investors have become ever more sophisticated at predicting future company earnings. Yet there hasn’t been any way to invest directly in company earnings streams, until now.
The invention of any new product is ultimately a response to latent demand or overt demand. Accordingly the latent demand for new markets in the financial sector typically follows a period of major structural economic change.
-Robert Shiller, Financial Innovation: Too Much or Too Little?
Here are 5 reasons why now is the time for earnings derivatives.
Democratization of Investment Research
It used to be that only Wall Street insiders had access to the best information and research resources. In modern times anyone with an internet connection has access to near endless information that can be used to analyze stocks. Alternative data sources are now widely available allowing smaller investors to make accurate granular predictions on business fundamentals and stock market trends. The rise of crowdsourced earnings estimates on Estimize highlights how amateurs can often beat Wall Street at estimating earrings accurately. Investors need new tools to profit directly from these newly available insights.
The Rise of Quantamental Investing
Quantamental investing refers to the blending of quantitative and fundamental approach. Quantamental managers invest heavily in data in order to combine bottom-ups company analysis with quantitative approaches to alpha prediction. Several hedge funds known primarily for their fundamental analysis have started hiring data scientists. According to Bloomberg, Steve Cohen’s Point72 Asset Management, Dan Loeb’s Third Point, and Paul Tudor Jones Tudor Investment Corp have built out quantamental capabilities. Similarly, many market makers and high frequency trading firms have also been adding staff with expertise in analyzing business fundamentals, not just technical trading signals.
With quantamental analysis, investors are now able to develop extremely granular insights into the drivers of value creation. It’s time for the investment products to catch up to these improved methods of analysis. Untangling individual value drivers into separate investment products with earnings derivatives creates myriad new ways to hedge risk and generate non-correlated returns.
Most publicly traded companies have traditionally provided earnings guidance to help investors forecast near term performance, and estimate company valuation. Although this practice is far from perfect, many investors rely on it in order to build forecast models and make decisions. Covid-19 changed all this. Most publicly traded companies suspended earnings guidance during the second quarter. Management teams have no way of predicting if we will face a second wave of Covid-19, or policy interventions will shutdown their businesses. Additionally there is more uncertainty around long term consumer behavior. Industries such as airlines might experience prolonged declines even if the pandemic subsides and policy opens up.
There is no such thing as consensus earnings any more. There is now a wider range of possibilities for future earnings than there has been in the past. This increases the potential value of a variant view on earnings, and the risk of negative surprises. Earnings derivatives are one way to maximize gains, and minimize risk.
Record High Valuations
Against this backdrop of uncertainty, most stocks are at or near all time high valuations. These high valuations are most extreme for the FAANG stocks, a small group of large cap tech stocks that are driving the broader market higher. No doubt FAANG companies are great businesses with a high probability of continuing to grow revenue and earnings. Yet that doesn’t mean their stocks will continue their upward trend, as lessons from the prior tech bubble show. If you bought Amazon in December 1999, you would have experienced a 94% drawdown, and waited 10 years to get ack to even, even as the company grew earnings 1495%. Other world beating tech companies such as Microsoft and Oracle took even longer to get back to even in spite of growing earnings.
Even investors who expect strong fundamentals to continue need to be concerned that earnings multiples will not stay high. Whether you’re bullish or bearish of FAANG stocks, if you have an edge in predicting business fundamentals, you might want to look beyond just direct equity positions and use earnings derivatives. Investors can use earnings derivatives to hedge or replace individual stock positions. The FAANG Earnings and FAANG Revenue indexes can be used for options and structured notes, along with a variety of other derivative products
Greater Policy Risk
Central bank independence died of Covid-19. Around the world government responses to the Covid-19 outbreak have been massive and taboo shattering. In 2019 the Fed balance sheet has expanded by more than it did in the four years following the 2008 global financial crisis. Fiscal and monetary policy have traditionally been kept separate, but are now hopelessly intertwined. Under the CARES act, the Treasury has capitalized a special purpose vehicle which the Federal Reserve can leverage 10 to 1.
Beyond the initial Covid-19 response, populist policies also continue to stimulate and disrupt the economy. These policies will cause uneven impacts in different sectors. Regardless of who wins this year’s election, policy shifts will impact the earnings power of some companies.
Navigating this tumultuous era requires adapting quickly and finding the right investment tools. BLX Global has developed a product lineup designed to help investors profit in these uncertain times. Click here to learn more about our indexes.