Don't Get Burned by Earnings

Earnings season can sometimes seem like a colorful but meaningless show. How to sort through the noise.

Earnings season is here again, leading many average investors scratching their heads as great money is made or lost based on numbers that fall short, or surpass estimates, by a penny or two. Good or bad earnings just might be the last thing a penny still can buy, in fact.

But even though such news is always very exciting, the question remains how valuable or relevant it is for retail-level investors. This is not a game that many out of the industry truly understand. Quarterly earnings might surpass last year's figures, and even analysts' consensus estimates, but really, in the end, what does that mean? Does it really say anything about the long-term value of the stock? Does it tell you about their cash on hand, recent moves made by management or how they might even use their bailout money? No, of course not.

Even more insidious is the general stench of corruption between analysts and those they cover that hovers over earnings. And if it's not corruption, it's incompetence.

Most famously, analysts relentlessly cheered on the dot-com bubble of the late '90s, with just a handful of "sell" recommendations being offered, despite the fact that the market was headed for a spectacular crash. As noted by Kent Womack, at professor of finance at Dartmouth's Tuck School of business, by the late '90s "buy" recommendations outnumbered "sell" recommendations by at least 50-1.

In many cases, such bizarre analyst shenanigans are still going on and are easy to find. For example, it would be hard to find a more dysfunctional firm than General Motors (GM). It's making a product fewer people want all the time, it's got enormous legacy costs, its chief executive just got marked-to-market by President Obama, its stock trades at less than a gallon of gas and it perpetually hovers near bankruptcy.

But for all this, analysts have, somehow, a glimmer of hope that things aren't really that bad at GM. Thomson Reuters rates it "neutral" but not "underperform." This raises some juicy questions including, then what does rate "underperform?" Enron? WorldCom? A Pontiac Aztek?

Standard & Poor's rates GM two stars. Again, if this is so, what could ever merit one star? Please tell me so I know to preserve it as something rare, like a four-leaf clover.

All this could understandably lead some investors to fear that this is a rigged game, and earnings are basically kind of a vaudevillian show. Lots of sound and commotion, but ending with a cream pie to the face.

This is basically what was asked of the Forbes.com Investor Team: Why should we care about earnings?

David Joy, chief market strategist and chairman of the Capital Markets Committee for RiverSource Investments, a subsidiary of Ameriprise Financial (AMP), notes that while earnings remain important, investors need to do some extra legwork to actually get some value out of them. Because the current environment is so depressed, current numbers are not a reliable indicator of normal earnings. In particular, he notes that during the current market tumble analysts were perennially late in recognizing just how dire things had become, with the market leading the way down, not analysts. As a result, you have to be quite choosy when you see analyst numbers. But when the Street is wrong it can yield opportunities for astute investors.

Matthew Lloyd, vice president and chief investment strategist of Advisors Asset Management, says that in momentum-based markets, like the present one, fundamentals and earnings are discarded, leaving investors to act on faith. But, again, totally ignoring earnings is also a mistake, he says, because those firms that can survive should boost investor's confidence a great deal.

Jeff Rubin, the director of research and a portfolio manager at Birinyi Associates, says that earnings matter, but only for the long run. Investors should recognize that companies will miss earnings, and that often it does not mean much. Again, investors can profit by Wall Street's over-emphasis on a single earnings report by having faith that when strong firms disappoint, it represents a buying opportunity.

Are Earnings Above Board?

Forbes: I want to ask about earnings. There are always surprises and disappointments, goosing or killing stocks, at least temporarily. But should investors really pay any attention this stuff? Earnings expectations are created by analysts who are often more or less being paid by the firms they covered.

Examples of recent, positive earnings surprises include Worthington Industries (WOR), a metals-processing firm. It surprised mightily on the upside recently, but over the past year, its stock continues to more or less track the market. CarMax (KMX) also surprised in a big way (by 1,600%), but again, it's about trading in line with the market over the past year.

So, why do we care so much about earnings and their various positive and negative surprises? And where would we better spend our precious time?

David Joy: Earnings are important. After all, it is what we are buying when we invest in equities. Importantly, many (most) companies issue earnings guidance, so surprises, by definition, represent new information that can move a share price.

In the current environment, earnings are obviously depressed, so you need to look beyond current numbers to make some judgment about the normalized earnings potential of companies. This determination has important implications for determining whether current valuations are attractive.

Analysts have recently been playing a game of catching up with the overall market in something of a race to the bottom. The market had recently declined to a much greater extent than earnings expectations, which have been subsequently downgraded with a lag. A few short months ago, consensus expectations for aggregate S&P earning were in excess of $100. In stages, they have been reduced to below $60, with some individual estimates in the $40 range. But the market led the way down, not the estimates. It seems now that the two are more reasonably aligned, but we will see. In other words, bottom-up earnings estimates have been too optimistic for too long. Only recently have they been revised to a point of being reasonable.

So, yes, earnings are important, but be careful whose estimates you rely upon. And if you think the Street is wrong, and prices reflect the prevailing wisdom, there may be an opportunity to profit.

Matthew Lloyd: The markets are not trading on what most have come to expect from the past. Fundamentals no longer are valid as the intrinsic value of companies business models offer little confidence. The questioning of leadership and business models' ability to survive multiple sigma events only increases the anxiety of an overly risk-averse investor. Technicals have offered a bit more substantive signals as of lately, but not enough for the average investor to go all in. The headlines of contradicting negative economic releases and a government saying anything in search of the silver bullet only becomes noise to the most interested investor.

What it leaves us with is a market trading on psychological factors.

This leads us to unreasonable swings in expectations. In momentum markets such as this, the fundamental and earnings are thrown out. We are left to faith in an economy that will recover. Faith is perhaps the scarcest commodity of all.

Discounting earnings is a mistake in our opinion. Those few companies and managers who are able to maneuver the land-mine-laden economic landscape should give an investor a large sense of confidence in the future. Through this unique economic point in history, new leaders and business models will transform the market dominators in the next growth phase.

Jeff Rubin: Earnings do matter, but only in the long term. A company that continually shows losses on EPS will eventually go out of business.

In the short term, earnings are far less important, and create noise. An investor should recognize that their "favorite" company will miss Wall Street estimates during the time they own it, that is guaranteed and that in general it does not mean much.

It has always surprised me that there has always been such a tremendous reaction to a stocks earnings versus estimates. I have long felt that it was not the earnings that missed but the estimates that missed.

I, for one, tend to pay more attention to a company's guidance, not so much for the next quarter but more so for the next year.

One thing investors can do to take advantage of Wall Streets folly of paying too much attention to a single earnings report is to be level-headed, and if it is a company that you already own and you still like, then use the weakness in the stock price as a further entry point.

Forbes: Thanks, Jeff. Just advancing some of your ideas here a little with this follow-up.

I think what many individual investors fear about earnings are that they are somehow kind of rigged. Estimates are based not on company health, but on last year's numbers--which may not have much to do with the price of tea in China right now. Expectations are created by a class of analysts many investors intuitively feel are really not on their side--we all know, by now, that they are kind of paid for by Wall Street one way or the other.

And beating such a number by a penny, or failing to beat it by a penny, causes all this commotion. And great money is made or lost in a day.

So, folks, please reassure me that earnings are germane, not rigged, and not part of a game that individual investors really shouldn't be playing.

Joy: I think that, as with most things, it depends on who you listen to. Some sell-side analysts do good work. Others rely too heavily on company guidance. Still others do good overall analysis but come up with lousy estimates. It would be difficult for individuals to separate these, so they are forced to focus on the consensus, which like any average will get you into the right church but maybe the wrong pew.

Lloyd: I agree with Jeff in that company guidance is more important at this point in time. I believe you will see a shift over the next few years in the validity of some analysts as the need of more substantive and relevant earnings estimations will be met. I would also concur with David in that the evaluation of the estimates will be more difficult for the average investor.

Rubin: David is right that there are some excellent sell-side analysts, and then there are the rest. The rest is a very big group.

Regulation FD enlarged that pool of other analysts, as companies now for the most part give an analyst all that is needed to determine within a penny or two what the earnings will be. Regulation FD has truly made most analysts obsolete.

Forbes: How has Reg FD made most analysts obsolete? (Open to all, as are all my questions.)

And since you all seem to agree that earnings and even analysts have some relevance, how should we average Joes find the "good" analysts, who are making the smart calls, and avoid the rest of the dross?

Lloyd: I believe it will be cost-prohibitive for the average investor as far as following top analysts. Since there will a prized few, the cost for their services will be in very high demand. Research will be more labor intensive and require more resources than most may be willing to allocate. Reg FD has led directly to a sterilized dissemination of information, which has led many analysts left to interpret versus verifying certain company information. Reg FD, like mark-to-market and the uptick rule (decimalization?) has had unintended consequences even if intentions were appropriate.

Rubin: Let me first dive into Reg FD. The regulation now requires that companies make sure they disseminate to everyone, all relevant information. The companies are now providing sales guidance/cost of goods sold guidance, marketing numbers, tax rates, etc. And the vast majority of analysts now just take the company-provided numbers and plug them into a "model," and out pops their estimated earnings or a price target.

In the past, the good analysts would have to check suppliers, visit companies or stores, conduct surveys. Now, very few do such labor intensive research

The average "Joe" can do as we do; that is, track what analyst say. We have created a database of the major firms and the major stocks to find which analysts are better than average, which we should listen to.

I know your first response will be, "that is a lot of work and not easy." My response back is if it took the average Joe 10 years to get $60,000 in their IRA, isn't it right that they spend six months investigating and studying the records of the analysts that they want to listen to. It is not easy, and requires work, but investing is not easy and requires work and diligence. If it did not we would all be as successful as Mr. Buffett.

Joy: I agree with both Jeff and Matt's responses. I'll add only one thing. Obviously, since it is our chosen profession, we love the pursuit of a sound and profitable investment idea. In my experience, most individuals do not share the same passion, only the satisfaction that comes from a positive return. So, for most it is best to leave the hard work to the professionals. It is hard enough for them.