- Chronic under-guiding by CFOs - and gullible analysts - resulted in 70% of companies "surprising" on calendar 1Q14 earnings.
- While we would tolerate this level of incompetence in no other industry, the earnings merry-go-round of under-guide and over-deliver has become part of the investing landscape.
- To stay sane and solvent in this upside-down environment, we recommend focusing on the long term rather than on the next 90 days.
With the calendar 1Q14 earnings season more than three-quarters over, a familiar drama is playing out. Analysts who in the final weeks of March had been busily scaling back EPS expectations are now responding to above-consensus results for their coverage companies by pushing estimates higher once again. Restrained by cautious guidance from CFOs, however, these analysts won't be too aggressive in boosting their expectations for the current quarter. And by late June, analysts will again be whittling down their outlooks - only to be met with the surprise of above-consensus results for calendar 2Q14 earnings in July, which in turn will prompt another round of EPS hikes.
While we would tolerate this level of incompetence in no other industry, the earnings merry-go-round has become part of the investing landscape. To stay sane and solvent in this upside-down environment, investors may want to do the unthinkable: look beyond the 90-day window and assess companies (and even their earnings expectations) in light of demonstrated revenue growth, margin expansion, industry positioning, and other long-term quality factors.
The Quarterly Dance
It is easy enough to see why companies under-guide earnings, but a bit more difficult to understand why analysts play along. A few decades ago, when the investor relations function was not as robust as it is now, companies pretty much ignored Wall Street. Quarterly results releases routinely ran two pages, including a few bland comments from the CEO and an abbreviated income statement and balance sheet.
As corporate America became more dependent on Wall Street for financing, and as financial services itself became one of the nation's biggest sectors, the results release grew into a multi-document package, with slides, transcripts, CFO commentary, and detailed financials. Relationships became so cozy between top investors and corporate executives that the SEC hatched its Global Settlement in 2003, shaking down the big banks for $5 billion, ending the "road show" culture, and creating fair disclosure practices. Reg FD (Regulation Full Disclosure) was enacted to ensure that material financial information was dispatched simultaneously to all concerned investors, not just to the big money before everyone else got a glimpse.
In the Reg FD era, companies have decided that "blanket" guidance - detailed financial forecasts disseminated to one and all - reduces the risk of censure from SEC for making disclosures to a select set of investors. Selective disclosure is still a reality; Goldman Sachs paid a $22 million fine in 2012 as a result of invite-only "huddles" between analysts, traders and investors. But most companies have discovered that it is easier and safer to tell every investor the same thing.
Which is not to say companies tell investors the correct thing. In fact, finance executives would be nuts to share their actual internal guidance. Consider the simple math. The stock market on average appreciates 10% annually and has done so for nearly a century. While seasonal variations are material (think "sell in May"), on a roughed-out basis that means the average stock appreciates 2.5% between quarterly results releases. Most companies issue very little in-quarter news or data that would be comparable in import and detail to the quarterly results release. Hence, the quarterly results release better be good - heck, it better beat expectations - or investors will be inclined to claw back some of the 2.5% appreciation garnered over the prior 90 days.
So the corporate finance team sweats and schemes and models, completes a best-efforts financial forecast including projected EPS - and then tells the Street that the company can earn 5% less than the model indicates. It is hard to argue with the logic of this practice. The 5% earnings "cushion" softens the blows from real world events, like retail days lost to the savage winter we just survived, or business lost to Russian sanctions or China's puzzling malaise, or really anything. In fact, wizened and battle-hardened CFOs may be inclined to factor in a 10% cushion - so that after real-world events have had their impact, earnings can still "beat" by 5%.
When companies issue guidance, analysts consult their models and makes estimates that do not always line up exactly with management's forecasts. Outliers might make a difference, if four or seven analysts covered a company. But when 20 or more analysts cover a company, something predictable happens: irregularities are smoothed out, and the consensus midpoint is almost invariably exactly at the guidance midpoint. So when companies issue a guidance midpoint, they know in advance where the consensus is going.
The Earnings Season to Date
Heading into calendar 1Q14 EPS season, the consensus forecast has been for total EPS growth (including mainly GAAP results and some companies chronically reporting non-GAAP results) of about 1%, according to Argus Chief Investment Strategist Peter Canelo. Earlier in the quarter, the pre-reporting consensus was modeling low to mid-single-digit EPS growth. Analysts scaled back expectations in response to the fierce winter weather, along with signs of consumer exhaustion in former fast-growing areas, most notably housing.
As of 5/7/14, 414 companies in the S&P 500 (83%) had reported results for calendar 1Q14, according to Bloomberg. On a market-cap weighted basis, calendar 1Q14 earnings grew 7.6% year over year; on a non-weighted basis, 1Q14 earnings were up 9.6% from the first quarter of 2013.
Among the 83% of companies reporting for the calendar quarter, 69% reported higher earnings (up an average 22.7%, unweighted), while 27% reported lower earnings (down an average 18.6%, unweighted). Positive "surprises" (against consensus expectations) were also recorded by 71% of reporting companies, while negative "surprises" were recorded by 20% of reporting companies. Of that number, about two-thirds have surprised by less than 10% relative to expectations, meaning a full one-third of companies beating expectations have done so by more than 10%. About 10% of companies have reported in line with expectations, meaning analysts are batting .100. And just less than 20% of companies have surprised to the downside relative to consensus expectations. In this group, about two-thirds have missed consensus by less than 10%.
How does the sector earnings map look? Consistent with our consumer exhaustion theme, Consumer Discretionary earnings are averaging a 4% decline on a share-weighted percentage change basis in 1Q14 to date. Consumer staples earnings are averaging a share-weighted decline of 1.9%. Also fractionally negative in the quarter is Materials.
The best EPS growth sector so far is Energy, with earnings up 19.4% for calendar 1Q14 to date. After that come Financial Services, Information Technology, and Industrials, all posting high- to mid-single-digit EPS growth. For now, we are excluding Utilities and Telecom Services, both of which have had too few companies report so far to draw material conclusions.
Finally, how does this quarter's sector EPS performance accord with sector stock market performance? We documented recently that Consumer Discretionary, the former leadership sector of recent years, was looking a little tired in the market. On a stock sector basis, Consumer Discretionary is down 5.2% year to date and down 3.2% in calendar 2Q14 alone. Like Consumer Discretionary, Energy's earnings (up 19% in 1Q14 to date) and stock performance (up 5.6% in 2Q14 to date) are well-aligned.
Not every sector is so neatly lined up with its EPS fundamentals, however. Although Consumer Staples earnings are down for 1Q14, the sector has jumped 3.0% year to date, with all but 20 bps coming in April. Double-digit earnings growth in 1Q14 has not helped Healthcare avoid a 1.1% decline in 2Q14 to date, although the sector is still up 4.4% year to date. And Information Technology cannot get any sugar; high-single-digit EPS growth in 1Q14 to date has yielded a 0.8% pullback in 2Q14 to date, and a tepid 2.1% gain year to date.
Surgeons removing wrong organs, lawyers whose clients all go to jail, carpenters putting doors where windows belong: none of that would be tolerated. But every 90 days, investors make their investment bets based on analysts' forecasts; are routinely greeted with above-consensus results; and move on blithely to the next quarterly report. The consensus on the consensus has to be that, as regards earnings accuracy, it is way below consensus.
Looking at the market through a 90-day lens may focus your trading skills. Our strategy is less about trading and more about investing. The reality is that 90-day trading strategies are built on the rickety foundation of a consensus, which is itself built on guidance from companies heavily incentivized to mislead. Toss in naval-gazing analysts, who trade EPS results not on how they line up with the prior year but on how earnings line up with their own forecasts, and the scenario becomes even more surreal.
We recommend that longer-term investors pay less attention to how a company's revenue and EPS perform against analyst expectations, and pay more attention to how revenue and EPS perform against the prior year and against peer-group growth rates for that period. Moving beyond the period, we believe investors would be well served to focus on longer-term fundamentals such as revenue growth, margin trends, technological differentiation, competitive advantage, finances, and valuation.