Second-quarter 2020 earnings report cards have been rolling in, giving investors a wealth of information on how businesses have been dealing with the worst of the economic lockdown. There has been no shortage of surprises, with many companies doing remarkably well -- some even getting a boost related to efforts to halt the spread of the COVID-19 pandemic.
Such is the case with economic downturns. Winning businesses keep winning, new winners are created, and the decline of those already struggling gets hastened. To help sort through the best opportunities from this downturn, I've been categorizing stocks into four basic groups:
- Stocks getting a bump from the pandemic
- Those growing in spite of the pandemic
- Stocks temporarily affected but still on solid footing
- Companies that need serious help (like an abrupt end of the pandemic) to survive
Groups one and four are attracting loads of investor attention, but exercising some caution here is a must.
Image source: Getty Images.
1. The great unknown isn't all bad
A rare and impactful event like the one the world currently finds itself in creates extreme uncertainty, throwing many organizations that weren't prepared for the unknown into treacherous waters. But for some, uncertainty spells new possibilities.
A handful of stocks have roared higher this year (and propped up stock indices overall, creating a perception that markets are totally disconnected from reality). And for some of these businesses, the jump higher is for good reason. E-commerce is one industry that was already growing fast and that has experienced booming demand amid the pandemic. Software services are another, as the digital world continuously increases in importance.
But danger could be lurking. The outsized benefit that some of these companies are getting due to COVID-19 won't last forever, but their stock prices seem to assume that they will. When the short-term shot in the arm wears off, an adjustment to share prices may be in order. One example that has already played out is Alteryx (AYX). Though the company has remained in growth mode (who's going to argue with a 17% revenue jump in Q2 2020?), shares had nearly doubled in value from the start of the year on expectations that there would be booming demand for data science software. While Alteryx's outlook going forward is far from shabby, it didn't warrant the run-up headed into the second-quarter earnings season -- thus the roughly 40% "readjustment" to the stock price over the last two weeks.
The lesson? It pays to think about whether short-term positive effects for some businesses will be enduring or not. And if they aren't enduring -- or never transpire as expected -- a surging share price can be a dangerous thing to chase.
2. Doubling down on longer-term secular growth trends
Rather than pile into hot stocks that may or may not be able to sustain their current momentum, a great place to look for stocks to invest in right now are those businesses growing in spite of the current world situation. Familiar names benefiting from long-term trends dwell in this realm. An example is digital ad and social media giant Facebook (META 2.33%).
Facebook indicated that its results were mixed during the pandemic. Revenue slowed to just 11% growth in Q2 (down from 18% in the first quarter) on lower ad spending, but was offset by higher social media user engagement. Despite an imperfect quarter, the business continues to chug higher, and though shares have advanced 27% higher this year, it's not a totally unreasonable amount given Facebook's financial strength ($58.2 billion in cash and short-term investments at the end of June) and highly profitable business model. It may not be a particularly exciting company anymore, but that doesn't mean investing gains aren't to be had.
3. Betting on a near-sure-fire (eventual) rebound
There are numerous other businesses that haven't fared so well, but nonetheless are on solid footing and stand to recover quickly as effects of the pandemic wear off. Google parent Alphabet (GOOGL 0.37%) (GOOG 0.32%) is one. Though search-based ads took a hit during the spring of 2020 and led to an overall 2% decline in revenue, its cloud computing segment stayed strong with a 43% increase. And as the economy begins to recover, Google's ad business almost certainly will too.
In decidedly less fit shape than the internet search leader is Comcast (DIS 0.92%). On the surface, this company doesn't look so hot as cable TV and phone subscribers flee. But high-speed internet is the main driver of results here (and a modern staple), and the broadcasting business is holding its own as well. Though revenue fell 12% during the second quarter, Comcast is still easily in profitable territory -- having generated $9.29 billion in free cash flow on revenue of $50.3 billion through the first half of 2020.
In spite of their flaws and pullback in growth at the moment, businesses like Google and Comcast will be just fine once the dust settles.
4. Stocks with a less-than-certain future
And now for the last group of stocks, those that really need COVID-19 to be beaten sooner rather than later. The travel, hospitality, and restaurant industries are examples of stocks that have been hit especially hard, but some investors have piled into some of these stocks as if they are nearly risk-free.
Granted, some of them have a lot to gain if they can survive. Within the cruise industry, Carnival (CCL -0.14%) comes to mind. As travel starts to open up again, shares trading over 70% lower than where they started 2020 could be in for a big bound higher. But there are ample risks. Substantial debt has been taken out to make up for the cash crunch with ships stuck in port. And once the industry can set sail again, it remains to be seen how quickly vacationers will return. Simply put, future viability (and just how profitable it will be) of the business model is far from certain.
Granted, not all stocks that dwell in this "uncertain" realm are an ultra-high-risk investment. Though sales took a 42% hit on the chin during the spring, I have a hard time imagining Disney (DIS 0.92%) being in serious trouble in another five years from now. Sure, its parks are currently under heavy restrictions, but the burgeoning streaming TV unit is picking up subscribers by the tens of millions each quarter.
The dominant movie studio is also testing the waters of new movie distribution. With the addition of Fox, Disney took 40% of the U.S. box office in 2019 and laying claim to seven of the top 10 grossing films. That gives it some serious power to try out the controversial (but potentially industry-disruptive) move of bypassing theaters and sending Mulan straight to Disney+ with a $29.99 price tag. And though it most certainly needs an end to COVID-19 if it wants its parks to be on a firm foundation again, Disney isn't at risk of going kaput anytime soon, with $23.1 billion in cash and equivalents on the books.
Nevertheless, thinking about what a company needs to recover (reliance on debt to make ends meet is a big red flag) during this current period can save an investor from later pain. So can thinking about the business environment post-coronavirus. Don't simply assume a surge in business growth in the last quarter is part of the "new normal." It likely isn't. Some prudence on both ends of the spectrum will go a long way toward building a solid portfolio for the decade ahead.
