Tuesday, July 5, 2011

WSJ: Why You Shouldn't Buy Those Quarterly Earnings Surprises

Good article in the WSJ for those newer to 'the game' that is earnings report season.  Almost every quarter 70%+ish of companies "surprise", and investors lap it up as if its never happened before.  This is a good companion piece from a blog entry from 2007 titled [Dec 5, 2007: The Games Analysts Play... Why No One Ever Says Sell]

  • Everyone loves surprises. But perhaps you shouldn't get too excited over them. This month, market strategists, television commentators and other investing pundits will bombard you with breathless updates on the percentage of companies in the Standard & Poor's 500-stock index that have reported profits even higher than what analysts expected—in Wall Street lingo, a "positive earnings surprise."
  • The percentage of companies that have beaten expectations often is cited as a barometer of corporate profitability, an indicator of how well the economy as a whole is doing or a predictor of where the stock market is going.
  • What goes unsaid, however, is that these positive surprises are becoming so common they are nearly universal. They are predetermined in a cynical tango-clinch between companies and the analysts who cover them.  
  • In the first quarter of 2011, according to Bianco Research, 68% of the companies in the S&P 500 earned more than the consensus, or median, forecast by analysts. What's more, that quarter was the ninth in a row when at least two-thirds of the companies in the S&P generated positive surprises—and the 50th consecutive quarter in which at least half of the companies surpassed the consensus forecast of their earnings.
  • Even in the depths of the financial crisis, from the third quarter of 2008 through the first quarter of 2009, between 59% and 66% of companies beat expectations, according to Wharton Research Data Services, or WRDS.
  • In short, there isn't anything surprising about earnings surprises. They aren't the exception; they are the rule. "All the numbers are gamed at this point," says James A. Bianco, president of Bianco Research.

  • What's going on here? In what used to be called "lowballing" but now goes by the euphemism of "guidance," an analyst will guesstimate what a company will earn over the next year or calendar quarter. Then the company "walks down" the analyst's forecast by providing a series of progressively lower targets until the analyst's prediction falls slightly below where the actual number is likely to come out. 
Then CNBC trumpets the beat, and the stock surges and we all clap like seals.

  • Voila: The company gets to announce earnings that are better than expected, while the analyst gets to tell his investing clients that his estimate was pretty accurate and conservative to boot.

And if you peeve off the CEO by not lowballing you tend to get shut out in the future.  All part of the 'game'.

  • With analysts playing the guidance game more than ever, their forecasts tell us less than ever about where the stock market is going. So over the next few weeks, don't be fooled into thinking that there is anything surprising about the flood of positive earnings surprises.

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