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Small Caps: Assessing Management Guidance and Analysts' Estimates

- By Robert Abbott

In the short term, stock prices may be driven by the events of the day, chaotic as they may be. But, in the long term, it's all about the fundamentals, particularly growth in earnings -- or lack thereof.

Thus, Ian Wyatt took a close look at financial projections and valuations in chapter 5 of his book, "The Small-Cap Investor: Secrets to Winning Big With Small-Cap Stocks."

The most common source of financial projections is the management guidance offered in quarterly and annual reporting. The advantage of this source is that management knows more about the company than anyone else and is best positioned to offer a forecast. On the other hand, there is also the self-interest of management. Fortunately, there are checks and balances that keep this self-interest relatively contained.

To do your own checking on management, look for these potential problems:

  • Incorrect assumptions. For example, Cynosure (CYNO) was faced with a possible loss in 2006 because of a legal dispute. The market discounted the stock because of the company's exposure, and that turned out to be a bad assumption. Had the worst-case scenario occurred, the effect on earnings per share would have been only 1%.
  • Wishful thinking. Human emotions get in the way of human logic, yielding a conclusion not based on evidence.
  • Continued current growth rate. While past performance may be a logical base for future estimates, there is a strong probability the growth rate will decline. Wyatt said, "Most growth trends tend to begin leveling out as they extend into the future; so, it makes sense to adjust future estimates to allow for this slow down in the future." This happened to Panera Bread (PNRA) in the decade before 2008.
  • Emphasizing larger competitors. Management may focus on their largest competitor, rather than on the small companies coming up from below. In the late 1990s, prominent internet search engines ignored Google (GOOGL); for example, AltaVista, a leader at that time, was focused on Yahoo.

When reviewing management's guidance, ask what kind of guidance it is. It typically comes in one of three levels:

  • Aggressive. The company takes the most optimistic point of view and ignores the potential need for cushioning or poorer-case planning.
  • Realistic. Management assumes a mix of good and bad news in trying to provide reality-grounded projections.
  • Conservative. Management understates expectations, sometimes out of genuine pessimism and sometimes in a bid to set up a positive earnings surprise in future reporting.

Analyst estimates can be helpful, but rarely for small caps. If many analysts are already putting out estimates, then the company is relatively well known, and its big earnings and share price increases are likely things of the past.

However, in those cases where analyst opinions are available, there are a couple of important points to remember:

  • Check the "integrity" of individual analysts by watching for differences between their estimated outcomes and final returns. Consistently missing the final results signals low integrity.
  • More credence should be given to management guidance than to analysts' estimates.

Wyatt also advised investors to beware of companies playing the earnings game. For example, a company may estimate it will earn 53 cents per share in the next quarter, and analysts accept that figure. But when the company reports at the end of the quarter, it comes in at 54 cents per share. The 1-cent surprise may then cause the stock price to pop.

These are a few of the "adjustments" that may be responsible for "surprises:"

  • Early booking of revenue without booking the corresponding direct costs.
  • Cutting down the bad debts reserve.
  • Speeding up the positive write-off of reserves.
  • Deferring expense payments and accruals.

The author noted that these explanations may sound plausible because they "mimic" legitimate adjustments made at the end of the quarter.

Turning to specific, fundamental metrics, Wyatt emphasized these:

  • Price-earnings ratio: More appealing companies -- with rapid growth, strong profit margins and a moat (competitive advantage) -- will have higher price-earnings ratios than less desirable companies. Note, too, that as companies mature, their price-earnings ratios usually goes down.
  • PEG, or price-earnings to growth: This calculation allows investors to see the valuation of a company in relation to its growth rate. Lower PEG ratios are more attractive than higher PEG ratios because it means investors can buy more growth for the same amount of capital.
  • Rate of growth: Small caps growing at more than 20% per year are Wyatt's target since they are the most likely to produce the most capital appreciation in the long term. However, buying growth stocks at any price is not advised.
  • Consistent management compensation: Stick with companies that keep their compensation at a reasonable level through a growth period. Wyatt warned that founders cashing in is a red flag; he pointed to the case of Cell Therapeutics (now CTI BioPharma Corp (CTIC)); in 2008 the CEO was being paid $1.50 for every $1.00 of revenue booked.

Finally, Wyatt offered five red flags. He said, "When the books are being adjusted to make bad news look better, you will see:"

  • High volatility, and unpredictability, in reported revenue and earnings.
  • Very high adjustments to core earnings.
  • Regularly making adjustments to previously reported metrics.
  • Flux in price-earnings and earnings per share.
  • Lack of consistency in key capitalization ratios, especially the debt ratio if it increases every year.

In conclusion, chapter 5 of "The Small-Cap Investor: Secrets to Winning Big With Small-Cap Stocks" covers the fundamentals and forecasts. In it, Wyatt offers advice on positive and negative issues that investors should know, including the price-earnings ratio, the PEG ratio, the growth rate and consistency in management compensation.

This article is one in a series of chapter-by-chapter digests. To read more, and digests of other important investing books, go to this page.

Disclosure: I do not own shares in any company listed and do not expect to buy any in the next 72 hours.

This article first appeared on GuruFocus.