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Investors in stocks want to improve on the "buy and hold" approach. They want to beat the market in good times, but especially to avoid bad times. This requires active management of your portfolio, including watching some key indicators. It does not require you to become a whirling dervish, making major allocation changes with each new headline.

In this series of posts I plan to identify the major elements needed for active and sound management of your portfolio. Today's installment takes up one of the fundamental concepts, using earnings to identify a favorable market climate. Future pieces will discuss risks, market timing, and asset allocation. In each case I insist on quantification of risks and opportunities.

While no single part of this approach is the complete answer, an investor who understands and follows any one of the elements will have a significant edge. Those who embrace the entire package will be able to enjoy rising markets while monitoring and reducing risk.

Understanding Earnings

If you could have a single piece of information about the stock market -- just one -- what would it be? My choice would be corporate earnings. As you will soon learn, the market agrees with me.

A long-term investor should think in terms of buying businesses, not just stocks. The flow of earnings is the payoff for sound choices. Chuck Carnevale has written extensively and convincingly on this subject. I especially recommend his "A Primer on Valuation: 8 Examples of How Earnings Growth Drives Dividends and Returns." Taking a few minutes to study these charts and illustrations will help you understand that "cheap" is meaningful only with reference to earnings, not price alone.

As a manager dedicated to finding value stocks, I always include Chuck's FAST Graphs™ as part of my research. (See here for a good description of what he calls a "tool to think with.")

Short term, the story is a touch more complicated. Each quarterly earnings report provides a small piece of an ongoing story. The questions abound:

  • Did the earnings beat expectations? The whisper number? Frequently the official earnings expectation is a "lower bar" as companies reduce expectations.
  • Did revenue beat expectations? We do not like companies that continually squeeze more earnings from reduced revenue, since we know that there is an end to that story. When revenue is lacking, the earnings "quality" is lower.
  • What is the outlook? Does management see things as continuing the trend? Getting better? Look out if it is getting worse!

There are other items, but outlook is the biggest.

With each earnings report we see how this plays out. There was a good recent example -- Accenture (NYSE:ACN) which beat on both earnings and revenues, but still declined over 8%. The key is understanding the outlook for the next year. This is why earnings experts emphasize the need to look beyond the numbers. Stock prices often move dramatically during the earnings conference call, as management provides more color and background.

It is true for individual stocks, but it is also true for the market as a whole.

The Best Earnings Forecasts

Economic forecasts cover a wide range of outcomes, and corporate earnings follow these fluctuations - and with much greater variations. What if we had a source of information that provided a forecast of market earnings that had an average annual error of only 0.6% over more than ten years? In 8 of 11 years the accuracy was within 10% of the final result. Overall, the results were a little too pessimistic, but not by much.

This is more than just good forecasting. I would give it an "A."

Here is the actual track record of these real-time forecasts.

Forward Earnings Summary
(Click to enlarge)

What is this great source? The much-maligned bottoms-up forecasts of the professional analyst community, as compiled by Thomson/Reuters.

The actual data show the inaccuracy behind one of the most deeply-held elements of Wall Street Truthiness. It is commonly believed that analysts are wildly optimistic and biased in the coverage of the firms they follow. Any time forward earnings estimates are mentioned, all of the pundits will agree that they are "much too high and must move lower." This is usually accompanied by citing numerous "headwinds," a favorite term for those using words rather than data. When this is mentioned on CNBC, the anchors will all nod wisely in their agreement.

If only someone asked the tough question about past records instead of posting something about "Street Cred" showing the success of their marketing departments! None of these pundits ever produces an earnings track record of his own.

The only big downside miss was the recession effect. An active investor needs to pay attention to recession risk.

The Squiggle Chart

The best way to understand earnings forecasts is to look at a "squiggle chart." You do this by picking a particular year. Let us try a few examples. In each case we want to go back about fifteen months from the last point on the line. We are trying to evaluate how accurate the forecast earnings were for the 12- month forward period.

  • 2006. Check out that orange line and you will see that the final result was much stronger than the forecast.
  • 2008. It was the start of the recession. Earnings collapsed and the one-year forecast was terrible.
  • 2012. The forecast did not change much. It started a little low, moved higher, and remained in an accurate range.
  • 2013. Estimates were too high in the first salvo (more than one year ahead of time) but have recently been in a narrow range. The jury is still out on the final result.

Forward Earnings 2013
(Click to enlarge)

The one-year forward estimates have proven quite accurate in most years, as you can see from the chart.

The Market Significance

Many pundits who have been completely wrong in their forecasts attribute record stock prices to the Fed, what I call Using the Fed as a Fig Leaf. The article shows that many of the problems from a few years ago are solved or much improved. Higher stock prices are justified on that basis.

But earnings are also part of the story, if you are willing to look forward.

Many observers simultaneously make two claims:

  1. Analysts are too optimistic so we should ignore future earnings estimates.
  2. When the "beat rate" is 65%, they say that the estimates were a lowered bar.

Does anyone else see the problem here? As the data show, the estimates are very good on a one-year forward basis.

The relationship between S&P prices and forward earnings estimates has been pretty dramatic over the last ten years. Here is a helpful chart from FactSet.

6-22-2013 5-28-39 PM
(Click to enlarge)

This approach is much better than the backward-looking Shiller CAPE method for those interested in current valuation. Even Prof. Shiller endorses staying fully invested while using CAPE as a sector selection method.

Conclusion

Successfully beating a buy-and-hold approach has several components. I will treat each in turn. This article emphasized earnings outlook as a key element. I will move on to consider specific risks, including recessions, as well as finding the right sectors and stocks.

Finding attractive investments requires looking ahead. It is easy to get mired in the many stories emphasizing "headline risk." I recommend finding the best method for predicting future earnings. The bottoms-up conclusions from analysts provide an excellent approach for our general outlook. You can monitor this important data at Fundamentalis, the site of earnings expert Brian Gilmartin. Here is a recent example post with an update on forward earnings.

We must also consider what P/E ratio is attractive -- also a subject for another day.

Source: Beating Buy And Hold: Understanding Earnings