Understanding earnings game by reading between the lines

US earnings season begins this week, with company results set to dominate the investment landscape in the weeks to come.

The day-to-day chatter is always about whether the big companies are likely to miss, meet or surpass estimates, but this tells you little about how the earnings game really works. Exactly how common is it for companies to “beat” estimates? Are the numbers gamed? Can investors profit by buying companies that deliver an earnings surprise or is it in the price within minutes? And how might investors spot when chief executives are lying about earnings?

It’s all about expectations

“Markets will react to the ‘news’ in the report but the way we measure the news has to be relative to expectations,” notes renowned valuation expert Prof Aswath Damodoran. A company announcing a 30 per cent increase in earnings may be seen as delivering bad news if investors were expecting a 40 per cent increase, just as a 30 per cent decline may be seen as good news if markets were expecting a 40 per cent decline.

“It is not the magnitude of the earnings change that matter,” notes Damodaran, “but the ‘surprise’ in the earnings, measured as the earnings change relative to expectations.”

Earnings surprises are unsurprising

Investors should not construe Damodaran’s words to mean companies that beat estimates will see their stock rise. Beating estimates is no remarkable achievement – it is the norm, with about two-thirds of companies typically beating estimates. In fact, more than half of US companies have beaten consensus forecasts for 63 consecutive quarters, even managing to do so during the dark days of 2008.

Analysts tend to be over-optimistic in their initial estimates, with companies guiding consensus forecasts lower over time. Eventually a conservative estimate is settled on that allows companies to deliver an earnings “beat” and keep the PR people happy.

Traders are wise to this trick, with many looking for the so-called “whisper number” on websites such as EarningsWhisper.com or WhisperNumber.com. Another such website, Estimize, says its crowdsourced forecasts are more accurate than Wall Street’s 69 per cent of the time.

Growth stocks face earnings pressure

Twitter shares lost a quarter of their value following its last earnings report in May, despite beating estimates. It is not an isolated phenomenon – young glamour stocks are often priced to perfection, putting them under pressure to live up to unrealistic expectations.

These expectations mean value stocks are much more likely than growth stocks to deliver better returns following earnings reports, according to one study. Another found growth stocks outperform cheap stocks when earnings news is positive, but the authors added: “When growth stocks disappoint, they underperform value stocks by substantially more than they outperform when the news is good.”

In other words, growth investorricing in the new information, is it too late to get in on the action?

Surprisingly, no. Research has found that while the bulk of the share price move comes in the days follDowing the earnings report, the stock usually continues to drift higher in the weeks and months following the earnings surprise.

Known as the post-earnings announcement drift, studies suggest this market anomaly is a case of simple investor inattention. One study, for example, conjectured that investors would be more distracted on Fridays. Sure enough, it found that stocks that announced good earnings news on a Friday saw much more price drift (a gain of 9.7 per cent compared to 5.1 per cent for non-Friday announcements) over the next 75 trading days.

Another study found price drift over the following quarter was much stronger if breaking news was issued on days when many concurrent earnings reports were announced – that is, when investors were too busy to properly process the news.

Whatever the reason, the research indicates there is no need to get involved in earnings guesswork and to buy a stock in advance of its report – investors can still profit by buying after the announcement.

Insider information?

Earnings season always brings a flurry of analyst upgrades and downgrades. You could make a tidy profit if you bought company stock in advance of such announcements – after all, recommendation changes can be market-moving events.

Some hedge funds, it seems, are well connected in this regard. A recent study looked at more than 70,000 analyst recommendation changes as well as the trading patterns of 57 hedge funds. Hedge funds tended to buy and sell in advance of the analyst changes, earning some nice short-term profits in the process.

Might they simply be skilled traders who correctly anticipate analyst activity? Apparently not – the study found no evidence of outperformance in relation to other stocks held by hedge funds.

A cynic might say that it’s not what you know that matters, but who you know.

Acting on analysts’ revisions

While some hedge funds might see analyst upgrades in advance, other investors are strangely slow to act on analysts’ earnings revisions. Analysts are constantly tweaking their earnings estimates, with downward revisions typically leading to rapid investor selling. However, professional investors are much slower to respond to upward revisions, according to

Leonard Zacks

of

Zacks Research

.

They are understandably sceptical, he says, given it is in brokerages’ interests to generate buying activity. As a result, they tend to hold meetings and delay making the decision to buy until the stock has already begun its rise.

Pet analysts

Firms try to prevent the revelation of bad news by “playing favourites” with certain analysts during conference calls, a recent study found. Companies that “cast” their conference calls by disproportionately favouring bullish analysts go on to underperform, according to the study, missing future estimates as well as being forced to issue earnings restatements. In the quarter following such conference calls, the researchers added, “significantly more insider selling” takes place. In short, beware of companies that shun sceptical analysts.

Decoding lying chief executives

How do you know if a chief executive is lying about earnings? According to one study that examined almost 30,000 conference calls with analysts, chief executives of companies later forced to restate earnings favoured overly enthusiastic words like “fantastic” and “great” over words like “good” or “solid”.

If the chief executive wants to hide bad news, expect to hear impersonal pronouns (“they”, “the team”) rather than “I” or “me”; more references to general knowledge (“as you know”); fewer direct answers and fewer “hesitation words” like “um” or “er”, presumably due to “having more prepared answers or answering planted questions”.

Swear words are also more common, the study found, which brings to mind the infamous case of former Enron chief executive Jeff Skilling. In a 2001 conference call, a sceptical hedge fund manager remarked to Skilling – who later received a 24-year prison sentence for fraud – that Enron was the "only financial institution that can't produce a balance sheet or a cash-flow sheet with their earnings". That prompted Skilling to retort: "Thank you very much, we appreciate it, asshole".