Analysis: PYPL SBUX

(This content was originally published as an Action Alerts PLUS Alert on July 22, 2016. Stock prices, shares held and portfolio positions may have changed.)

We often discuss the important role expectation management plays in guiding our investment decisions. When a company reports earnings, it is not uncommon to see a prestigious financial newspaper (or other media outlet) run a provocative headline to the tune of "Company A Sees Strong Growth in Online Payments" or "Company B Cuts Sales Forecast as Growth Slows."

Using headlines alone, blinded to any other data, which stock would you guess is outperforming? Which one is selling off? Certainly, investors would appreciate a company that sees strong growth in its industry over one that just cut its sales forecast amid slowing growth.

If the stock market operated within a vacuum, then this assumption would be true. However, the stock market operates on a continuum of relativity. Thus, it is not the magnitude of the company's reported earnings change that matters but the "surprise" in the earnings, measured as the earnings change relative to expectations.

Enter PayPal (PYPL)  and Starbucks (SBUX) . PYPL is "Company A" and Starbucks is "Company B," with both headlines coming from distinguished financial news outlets. Shares of PYPL are trading nearly 7% lower while SBUX is trading solidly higher.

In respect of PayPal, we explicitly encouraged members to trim their position into earnings. At the time we published the note, shares of PYPL were trading above $40, near all-time highs and 12% above our cost basis. In light of the run, we viewed it "prudent to lock in profits ahead of the company's second-quarter earnings release" and explained that "we would not be surprised to see PayPal deliver solid results, but recognize anything less would cause investors to punish the stock. We encourage members to lock in some profits."

Our rationale for slashing ahead of the quarter was quite simple: PayPal's strong track record of earnings beats heading into yesterday's results was, in our view, a double-edged sword: "On one side, it signifies strong execution and expectation management; on the flipside, it creates unrealistic expectations, as investors price in better-than-expected results and prove unwilling to settle for anything less. Simply put, we believe the risk/reward is skewed to the downside."

PayPal's 15% year-over-year sales growth (20% excluding currency impact), 11% earnings per share (EPS) growth, 25% transaction growth and nearly 30% total payment volume growth are remarkable on the surface, any way you spin it. However, each metric fell precisely in line with consensus expectations, marking the first quarter in the company's history in which it failed to deliver a sales/earnings "beat" (above consensus). We suspect today's selloff is driven by relative disappointment. PayPal likely fell victim to playing the earnings "game," which involves managing expectations and tweaking earnings to beat expectations, yet backfires once investors adapt to the game. Firms that consistently beat consensus estimates now have to beat them by a wide "margin" to elicit a positive share price reaction.

Starbucks, meanwhile, certainly had a disappointing quarter, "missing" consensus estimates on the all-important same-store-sales growth figure. However, investors had priced in the relative earnings risk heading into the quarter, which is why we purchased 300 shares at roughly $57 on Wednesday . As we mentioned on the members-only monthly call Wednesday, this was the first quarter in recent memory where Starbucks' expectations were muted. After reporting disappointing results in each of its past two quarters heading into Thursday, investors had lowered their expectations and thereby the hurdle.

Bottom line: Earnings results should always be analyzed through the lens of relativity, which is driven by investor sentiment, not sell-side expectations. Our decision to add to Starbucks at roughly $57 a share and recommend members slash their existing PayPal position at $40 a share ahead of their respective quarters was driven by the realization that investor expectations for PayPal were impossibly high, while expectations for Starbucks were uniquely low.

At the time of publication, Action Alerts PLUS was long PYPL and SBUX.