Earnings Surprises...Are You Kidding Me?
In the game called the quarterly earnings season, positive surprises have become so commonplace among US large-cap stocks that they’ve nearly lost all meaning. We wonder why investors keep playing along.
The media are an integral part of the entertainment, cheering or booing companies from the sidelines as if earnings season were a sporting event. This incessant focus further feeds the earnings-surprise fervor.
The assumption is that a consensus-beating company is healthy and performing well or that macroeconomic conditions are improving. But here’s the thing about so-called earnings surprises: they depend not only on what companies are doing but also on what sell-side analysts are doing. And sell-side analysts have been doing some odd things lately.
The display below shows the progression of consensus earnings estimates for the aggregate of S&P 500 companies for calendar years 2013, 2014 and 2015. As the downward slope indicates, analysts’ forecasts for each forthcoming year started out wildly optimistic (in retrospect) and were steadily pruned as reality (and actual results) set in. As each year drew to a close, positive earnings surprises became more frequent.
The problem with this earnings-season gamesmanship is that it deprives investors of a truthful reading of economic and corporate developments. That’s because earnings beats are no longer special; they’re the norm. On average, 69% of US large-cap companies have surpassed their consensus estimates over the past 28 quarters. Even at the depths of the 2008 financial crisis, more than 50% of S&P 500 firms posted positive surprises (Display). On-target reports have become a rarity.
The Lake Wobegon Effect?
If analysts were consistently applying their best guess to their earnings forecasts, the consensus average of positive surprises would tend to fluctuate around 50%, not 69%, over the long term. After all, the distribution of forecast errors should be random unless economic or company fundamentals change (and assuming that analysts as a group do not have a crystal ball). But the forecasts are biased, so the frequency of error is too: after the initial burst of optimism, analysts appear to be lowballing estimates whether fundamentals are improving or not—and positive surprises are the result.
To illustrate the irrelevance of upside surprises at the stock level, consider Goldman Sachs’s experience (Display). Over the past 10 years, Goldman Sachs missed quarterly estimates only six (depicted by green diamonds) out of 39 quarters. Even when analysts were trimming their estimates, the company still managed to top them (as depicted by the blue diamonds). In 2008, as the business was deteriorating, Goldman beat Street estimates in two of the four quarters, with the biggest miss coming in the fourth quarter, when earnings fell short of consensus by 106%. By then, the stock had already plunged 64% for the year.
This is far from an isolated phenomenon. We’re not saying that all positive surprises are devoid of relevance or that they should be ignored entirely. But we think they need to be viewed on a case-by- case basis and with greater skepticism. In our view, it should be up to the market—not analysts or news organizations—to determine whether an earnings report is a surprise or not. As a general rule, we think a company’s results should only be deemed a positive surprise if the stock outperforms the market immediately following the earnings release, and disappointing if it underperforms. This should be obvious, but you wouldn’t know it from the media’s hyperbolic focus on the consensus scorecard.
The situation has reached a point at which analysts, when previewing company earnings prospects, frequently declare that they do not expect any “surprises.” But the point about surprises—real ones, at least—is that they are unexpected. What analysts actually seem to be saying in these instances is that their estimates might be accurate for a change.
If a company cannot be judged by whether it is beating consensus, then how should it be judged? We believe an analyst’s efforts would be better spent investigating and providing insights into company fundamentals, particularly as they relate to the firm’s long-term potential to generate profits above its cost of capital. Our research and experience show that a business’s excess return on invested capital (ROIC) is a highly reliable predictor of that company’s potential for above-market stock returns. Those odds tend to increase even more when a firm’s ROIC is improving.
Our advice: tune out the talk of earnings surprises and tune into information on company fundamentals, and especially ROIC—or, in other words, the factors that really matter in the pursuit of investment outperformance.
(c) Alliance Bernstein