Quality of earnings = Extent of misses and hits = Price reaction?
So, Quality of the earnings = Price reaction?
Many tend to “read” companies’ earnings based on (a) how well they beat the analysts’ expectations and raise their guidance and (b) the share price action reacting to their earnings to conclude how well the companies fare.
It is a shortcut of their understanding of the quality of the earnings to just the initial share price reaction; this sort of embracing the “efficient market hypothesis” where we assume share prices reflect all information.
A typical chat with a retail investor can be:
Question: How are the earnings for Company X?
Response: The share price dropped 7%; not good.
Distortion (1): Expectations before the results
Generalising earnings and expectations with price actions can be complicated.
High expectations
When a company is highly valued, they have high expectations and are priced for perfection. This can be made worse when the share price had been rising before the earnings release. Any slip in the metrics showing deceleration and weaknesses can cause the price to fall. At times, the share price would just drop even with a “beat and raise” earnings; not good enough with the high valuation and/or traders just profit-taking.
Low expectations
Some companies have been doing badly and the stock has been threading at a low. They can be heavily shorted. The market does not think highly of the companies and some may have a low probability of survival. Unexpected good (less bad) earnings can cause the share price to spike up with short covering. It does not mean that the company’s fortune has turned good for the longer term.
Distortion (2): Quarterly triple play
A triple play is when a stock simultaneously beats analyst expectations for revenue and earnings and also raises earnings guidance for the next quarter and the financial year. Again, focusing on the ability of the company to meet and raise quarterly earnings and guide is akin to taking a snapshot that may not be representative of the quality and long-term prospects of the company.
Example: A company may be expected to grow its revenue by 25% for the quarter though the actual growth rate comes in short at 23%. The miss (and the share price reaction) becomes the main focus despite its 23% growth (which many may not be aware of) as well as its business progress towards its progress and operating and financial metrics (double emphasis that many do not delve into). Over time, while the market focuses on the hits and misses against expectations, the company may have been growing at an average of 20% annually (which many do not follow). Alas, suddenly, we realise that the share price has been inching up over time along with the company’s long-term performance, achieving good share price appreciation.
We take a snapshot focusing on earnings’ hits and misses and the initial share price’s reaction that we miss the quality and longer-term growth prospects of the companies.
By focusing on a triple play, we assume that they sum up the earnings well and ignore many aspects of the companies that may show high quality and potential.
Distortion (3): Managing expectations
Companies do put in low (conservative) expectations. Its share price may drop due to the low guide. When they do well in their quarterly earnings and raise their annual guide, the share price can shoot up significantly due to buying interest and short covering.
Distortion (4): Sentiment of the day
The sentiment of the day can play a large part in the price actions. It is heavily affected by the news and release of important economic data. Hence, the price actions can be distorted more by the overall market sentiment than the earning releases.
Efficient market hypothesis?
By equating the initial price reactions to ascertain earnings, we assume (implicitly) that the share prices reflect all information (efficient market hypothesis) and the wisdom of the market participants.
No, this is too simplistic and too generalising.
I’m convinced that there is much inefficiency in the market. These Graham-and-Doddsville investors have successfully exploited gaps between price and value. When the price of a stock can be influenced by a “herd” on Wall Street with prices set at the margin by the most emotional person, or the greediest person, or the most depressed person, it is hard to argue that the market always prices rationally. In fact, market prices are frequently nonsensical.”
Warren Buffett
People are ruled by emotions and are not always rational. George Soros believes that “what beliefs do is alter facts”. He calls this “reflexivity,” similar to a feedback loop or an echo chamber.
I believe that market prices are always wrong in the sense that they present a biased view of the future. But distortion works in both directions: not only do market participants operate with a bias, but their bias can also influence the course of events. This may create the impression that markets anticipate future developments correctly, but in fact. it is not present expectations that correspond to future events but future events that are shaped by present expectations. The participants’ perceptions are inherently flawed, and there is a two-way connection between flawed perceptions and the actual course of events, which results in a lack of correspondence between the two. I call this two-way connection “reflexivity”.
George Soros
Zoom out: Focus on the quality and long-term potential of the companies
Relying on short-term price action as a shortcut to deduce the quality and strength of the companies can be deceiving and easily tricked by the market. The market’s focus on earnings can be short-term and may not be right in the longer term.
Few spend time to delve deeper into studying the earnings releases themselves and compare them to past earnings and those of their competitors. We are not updating ourselves about the company and its long-term potential vis-a-vis its operating environment.
Unless we are short-term traders, we are following the market with headline news and their price actions — a herd mentality and a shallow understanding instead of having an independent and long-term investing thesis of the companies.
High-quality companies ≠ Perfect companies
High-quality companies can grow consistently on a longer-term basis but they cannot always grow and beat expectations every quarter. They are high-quality but not perfect companies.
Many investors are so focused on the companies’ ability to “beat and raise” that they do not track their growth and progress over the long term. Despite misses, hiccups, possible pessimism and ‘this time is different’, these high-quality companies soldier on to achieve good compounded annual growth rates in the longer term. Over time, we will notice a correlation between their share price appreciation with their financial performances.
Some market participants rely on others (analysts, social media, friends) for analysis, some look at share prices as the reflection of the earnings, some delve to do the analysis themselves, some use charts and some react to emotions in their investing decisions. Everyone has different reactions.
When there is a plunge in share price after earnings, investors can become reactive; panic and be more inclined to sell or hold it hoping for the better. It could be a case of the company’s deteriorating competitiveness that we should exit from the investments. Sometimes, it could be due to tough luck, abrupt changing situations, or the company working on a longer-term plan that sacrifices short-term performance resulting in a blip that we may consider adding. Acquisitions and aggressive reinvestments are often not viewed favourably by the market and analysts, especially during the down cycle.
As investors, we need to study the earnings to evaluate whether (a) their moat is strengthening or weakening, (b) the long-term prospects are still good with their current position in the operating environment and (c) any concerns that need to keep a lookout for in their subsequent few earnings. These will help to ascertain whether the current earnings hits and misses are temporary.
Do our due diligence. Focus on the long-term. Zoom out.
Good references:
McKinsey & Company: Avoiding the consensus-earnings trap
1988 Berkshire Hathaway’s letter to shareholders (on the efficient market hypothesis)
‘The Market Is Always Wrong’: In Defense Of Inefficiency
