Estimate Revisions and 'The Earnings Season Racket'

Doug Kass penned a column for TheStreet.com on Wednesday titled "The Earnings Season Racket." Kass argues that the earnings "beat" rate is so high this quarter because of lowered estimates, and that "companies almost always beat earnings forecasts even during rough economic periods." Below is a portion of his column:

While it has been widely advertised by chest-thumping bulls in the media that at least two-thirds of the companies that have reported third-quarter earnings have beaten forecasts, there was less than meets the eye to third-quarter profits as in many cases the "beats" were on lowered estimates.

What is often being ignored is how orchestrated earnings season has become, not only that the beats are from lowered and depressed guidance but that, in many cases, there have been high-profile forward-quarter guide downs.

The reality is that companies almost always beat consensus earnings forecasts, even during rough economic periods. Investor relations departments and Wall Street analysts are very good at getting numbers down to the right level before reports are released. As a result, the actual results vis-a-vis expectations or consensus do not vary materially from historical experiences, in good times and even in bad times.

The argument that earnings are beating estimates simply because estimates had gotten so low has been one that bears have been using this entire bull market. In reality, however, estimates have increased significantly in recent months. Back in October 2008, net earnings revisions (% of increases to decreases in revisions) had tanked to multi-year lows. But it also bottomed that month and then traded sideways until February 2009. Just prior to the market lows in March, however, the net earnings revisions ratio began to tick higher. Earlier this summer, the earnings revisions ratio actually moved into positive territory, which meant anaysts were raising estimates for companies more than they were lowering them. Leading up to this earnings season, the percentage of companies raising estimates hit a two-year high. Upside estimates have been outpacing downside estimates for a few months now, and companies have still been able to beat estimates at a high rate, which we believe is a major reason for the rise in the overall market.

Kass' argument that companies almost always beat consensus forecasts even during tough times also needs some explaining. Over the last decade, 62% of the tens of thousands of earnings releases were better than analyst expectations. But the beat rate has had pretty big swings from a quarter to quarter basis that has ranged from 50% to nearly 75%. While the majority of stocks are going to beat in any given quarter, some quarters are significantly better than others.

Below is a chart showing the quarterly earnings "beat" rate going back to 1998. As shown, the beat rate was strong during the last couple quarters of 1999, and it peaked in Q1 2000 just as the market peaked. From that point until Q3 '01, the "beat" rate remained below 60% and trended lower. From Q4 '01 (which would have been the numbers released in January/February 2002) to Q1 '04, the beat rate progressively increased each quarter. This coincided with a big increase in the stock market as well. The last peak that we saw in the quarterly "beat" rate came in Q3 '06 when 73% of companies beat estimates. The number remained above 60% through Q3 '07, but it had started its drift lower. This downtrend continued all the way until Q4 '08 (numbers released in January/February '09) when the "beat" rate hit a low of 55%.

The earnings season in April and May of this year was the first increase in "beat" rates since Q1 '07. In that earnings season, the "beat" rate came in at 62%, which was surprisingly positive at the time, and one reason why the market did very well during over the spring and summer. The "beat" rate got even better last earnings season (68%), and we're on pace to have the best "beat" rate since at least '98 this quarter.

To brush off the earnings "beat" rate because earnings "almost always beat estimates" is not a good idea. We believe it's important to follow the trend in quarterly "beat" rates, as a trend higher is indicative of a strong market, while a trend lower is a negative sign. Surprisingly better than expected earnings reports have been a big part of the current bull market.

If Kass wants a bearish argument, he could actually make the case that the high "beat" rate this quarter will most likely be the peak in the cycle since it is so high. It's going to be tough for the next earnings season to have a stronger "beat" rate than this quarter, which could mean the start of a downtrend. But nowhere in Kass' column does he mention this.

In conclusion, the data shows that companies have been beating raised estimates and not lowered ones during this bull market, and the direction of quarterly "beat" rates is a trend that investors should definitely follow.

Comments

[logicalthought:]

Being the "highly sophisticated traders" that they are they'll never admit it, but "earnings beat buyers" must all be big fans of the efficient market theory, because they're basically thinking that if a stock was priced at "x" when people thought the earnings would be even WORSE, that stock must now be worth "x + something".because of the "beat". The problem with this argument in the current environment is that even on a "beat basis" stocks are ridiculously expensive. Q3 S&P earnings will be around $15 and thus annualize at $60, thereby providing a run rate PE of 18 in a (mostly) sequentially flat-to-slightly-better and year-over-year severely NEGATIVE revenue & earnings comp environment (and the 2008 comps were ALREADY terrible vs. 2007). So, anyone who's ready to pay current prices for stocks is either looking for a greater fool or better believe we're going to have one hell of a booming 2010 (which, by the way, begins in around nine weeks, so I guess it's back to looking for that "greater fool").

Oct 23 11:19 PM

[Alex Filonov:]

I would more agree with Doug Kass: earnings management reached new heights lately. I'm not even looking at profits this quarter. Top line beats deserve respect, bottom line, not so much.

Oct 24 12:02 AM

[Moon Kil Woong:]

It would be helpful if analysts didn't just mime company's estimates or make so many obvious straight line assumptions. Usually companies adhere to the financial wave like up and down cycles of the markets they are in. Perhaps they never took Trig in school.

Often markets already assume a company will beat estimates. You can see this in the options interplay and the after the fact stock price comedowns when they fail to beat the expected beat rate.

It is true analysts are fallible. I just wish brokerages would market their research more factually. Analyst reports are good for compiling snapshot insight and trends for a company, often made my Dataquest or others, and brush reviewing financial reports and oddities for all those who lack the time, willpower, or ability to do so themselves. And last, they remain great at moving the markets for no apparent reason other than their brokerages getting their readers to buy at the same time (which might I point out is usually one of the most adverse things to do over the long run). Volume is the diver for brokerages to post reports, possibly making their clients money is only incidental.

Oct 24 12:59 AM

[tripleblack:]

Absolutely agree. Those straight line assumptions are starting to give me a rash. EVERY piece I read yesterday included them as a piece of foundation, if not the whole foundation.

Oct 24 06:17 AM

[logicalthought:]

"Top line beats" don't deserve any "respect" if, on an absolute basis, the number still sucks.


On Oct 24 12:02 AM Alex Filonov wrote:

> I would more agree with Doug Kass: earnings management reached new
> heights lately. I'm not even looking at profits this quarter. Top
> line beats deserve respect, bottom line, not so much.

Oct 24 08:09 AM

[enigmaman:]

You said "In conclusion, the data shows that companies have been beating raised estimates and not lowered ones during this bull market, and the direction of quarterly "beat" rates is a trend that investors should definitely follow."

The question is "Was the earnings bar they beat set to low", thats wasn't adequately addressed.

The chart indicates earnings beats bottomed at the end of 08 and have risen every quarter since, should we take this is an indication that better times are ahead, the authors seem to think so.

You said " We believe it's important to follow the trend in quarterly "beat" rates, as a trend higher is indicative of a strong market, while a trend lower is a negative sign"

Im very pleased to hear that this is a strong market that has rocketed higher in spite of the economy itself remaining in ICU, the liquidity play that everybody talks about, the reason for this rally has nothing to do with fundamentals, so the so called strong market is not a result of a strong economy, I guess the disconnect is the new normal often spoke of, You know where " everybody wants to go to heaven but nobody wants to die" like you can have one without the other, have your cake and eat it to, so yes It appears we can have a strong market without a strong economy, because its different this time!

Oct 24 09:32 AM

[Econ 1:]

My respect for Bespoke aside--"beats" are at best a sentiment indicator that may only show the sentiment of the Wall St. Brokerage apparatus-- So maybe still useful in that light but:

>Surprisingly better than expected earnings reports have been a big part of the current bull market.<

I am not sure I would give the "Beat Ratio" that much credit. As a fairly newbie investor I really do question analysts integrity in general (they earned that). That said, who IS doing all this buying? The $100 question still remains to me -Bear Market Rally- or leg one of the most -Hellacious Bull Runs- ever known to man. It's time to bet the farm on one direction or another, people, because I am told this is when fortunes are made or lost!!! Who's with me!!

Oct 24 10:21 AM

[davidbdc:]

If they changed the definition of "beat" to something over 10% profit or a penny (whichever is greater) then you'd probably find many fewer beats historically.

Who cares is basically my response anyways. I buy dividend paying stocks and pay attention to the underlying business results. Some people like buying flash and glam.....thats their right, I'll stick to the cash flow.

Oct 24 10:46 AM

[Swashbuckler:]

Much of the earnings "beats" are a result of layoffs and and other expense reductions which will not be repeated going forward (nothing left to cut), and have sacrificed long term profits for short term relief.

Oct 24 11:23 AM

[codeman:]

Earning! Where is the devaluation of the dollar calculation.

Oct 24 12:23 PM

[market ace:]

This "beats" stuff sounds silly to me. As a former CFO of public companies I can sure you no company is going to estimate future earnings any higher than absolutely necessary not to cause a panic and the upside estimate will always be low enough that the we expected to beat it easily. What company would be stupid enough to estimate earnings that they did not expect to beat handily.

But since no one cares about fundamentals any more, I guess this hocus pocus method works as well as any other.

Oct 24 12:35 PM

[Wisdom vs. ...:]

nonsense. managers and analysts underguide to avoid lawsuits, so curse the lawyers and judges, not the CEOs and analysts.

short term, you can manipulate investors into buying stocks with a beat, but in the long term the only thing that matters is earnings; not to mention, most investors know that companies usually beat thus change their expectations. you can argue beats encourage people to buy who should not, but you cannot argue experienced investors are effected. GS was an excellent example this Q, they were priced for a higher beat, beat by the usual amount and got hammered-- fact is, investors know.

another problem with forecasting is that you never know when GE is going to make a $1.7B loss at GECS look like BE (which will hurt earnings down the road), or when INTC is going to write off goodwill in a bad Q for tax purposes (which will boost earnings down the road).

most importantly, analysts don't owe you anything unless you paid them, they are not public servants; an analyst is only going to tell you what to do after his customers have moved. D Bove had a brilliant comment recently, everyone wants analyses for free now, and they are getting what they paid for

Oct 24 01:24 PM

[untrusting ...:]

enigmaman,
John Hussman has a very good new article on the current state of the US markets and his take on it. See the link below.

www.hussmanfunds.com/w...

Well worth the time to read it as well as the link, in the article, from one of his top staff on the earnings beat concept.

We think Hussman provides some of the most realistic, fact-based and logical commentary on the markets. Not to mention that they spend millions on research and have some pretty smart research talent on staff as well. Note that we have no postion in any Hussman funds, but certainly appreciate the fact that they are willing to provide their overview to the public for gratis. Whether one agrees or disagrees with their view, it is always supported with a strong basis in data and comparative analysis.


On Oct 24 09:32 AM enigmaman wrote:

> You said "In conclusion, the data shows that companies have been
> beating raised estimates and not lowered ones during this bull market,
> and the direction of quarterly "beat" rates is a trend that investors
> should definitely follow."
>
> The question is "Was the earnings bar they beat set to low", thats
> wasn't adequately addressed.
>
> The chart indicates earnings beats bottomed at the end of 08 and
> have risen every quarter since, should we take this is an indication
> that better times are ahead, the authors seem to think so.
>
> You said " We believe it's important to follow the trend in quarterly
> "beat" rates, as a trend higher is indicative of a strong market,
> while a trend lower is a negative sign"
>
> Im very pleased to hear that this is a strong market that has rocketed
> higher in spite of the economy itself remaining in ICU, the liquidity
> play that everybody talks about, the reason for this rally has nothing
> to do with fundamentals, so the so called strong market is not a
> result of a strong economy, I guess the disconnect is the new normal
> often spoke of, You know where " everybody wants to go to heaven
> but nobody wants to die" like you can have one without the other,
> have your cake and eat it to, so yes It appears we can have a strong
> market without a strong economy, because its different this time!

Oct 24 06:17 PM

[Benito Camela:]

You can basically write anything regarding "manipulated earnings". It is amazing that people even read these "jokers"

The thruth is given by fundamentals. The enconomy is still going donw the tubes, even after all the government freebies, the Feds low-interest subsidy and the accountants imagined profits...

Be ready for the big leg down in 2010...

Oct 24 06:52 PM

[enigmaman:]

Yes I read him, thank you


On Oct 24 06:17 PM untrusting investor wrote:

> enigmaman,
> John Hussman has a very good new article on the current state of
> the US markets and his take on it. See the link below.
>
> www.hussmanfunds.com/w...
>
> Well worth the time to read it as well as the link, in the article,
> from one of his top staff on the earnings beat concept.
>
> We think Hussman provides some of the most realistic, fact-based
> and logical commentary on the markets. Not to mention that they spend
> millions on research and have some pretty smart research talent on
> staff as well. Note that we have no postion in any Hussman funds,
> but certainly appreciate the fact that they are willing to provide
> their overview to the public for gratis. Whether one agrees or disagrees
> with their view, it is always supported with a strong basis in data
> and comparative analysis.

Oct 24 07:45 PM

[Alan Young:]

There is often a good reason for a stock to go up on an earnings beat: even if the estimates were lowballed, the stock is priced to the estimates, more often than not.

But what gets lost in the shuffle is the quality of the earnings. Earnings from increased sales and organic growth are bullish. Earnings from reduced expenses, not so good: this often reduces future profits.

Okay, you all knew that, but with all the noise about the flim-flam, I just felt it needed to be said.

Oct 24 11:45 PM

[Chandragupta:]

Comparisons with Earnings Estimates are meaningless. What matters is the absolute change vis-a-vis previous periods. Also, earnings can be easily manipulated, but revenues are more difficult to manipulate. Hence, look at the revenue growth to really understand whether things are improving or getting worse.

Oct 25 05:38 AM

[rich168:]

the rally is fueled by low fed funds rate.

Banks are lending to stock brokers... for margin use

Oct 26 11:31 AM

[MarketGuy:]

"The argument that earnings are beating estimates simply because estimates had gotten so low has been one that bears have been using this entire bull market."

You mean "this entire bear market rally". Your bias is bleeding through.

Oct 26 11:32 AM