As one who has done extensive research over the past 25 years on earnings surprises, I remain puzzled why every quarter investors react to earnings news.
Most quarterly earnings reports are pure noise with little true investment information. Nonetheless, today’s day-trading mentality requires that noise be treated as critical information. Why anyone would want to structure investment strategies based on reacting to public information rather than on attempting to anticipate that news based on proprietary fundamental analysis has long been a mystery to me.
Despite my disdain for the quarterly earnings circus, there is generally better news in this quarter’s earnings reports. However, my interpretation of the quarter so far is quite different from the generally held one.
A critical aspect to analysing earnings surprises is the fact that there has been a secular increase in the proportion of companies reporting positive surprises which dates back more than 15 years. This clearly can’t be attributable to a secular improvement in earnings because the volatility of reported earnings has been historically high for many years. (As an aside, the persistence of extraordinarily high levels of S&P500 earnings volatility is one reason why overall equity market valuations should be considerably lower than have been this decade’s typical valuations.)
In the mid-1990s, the proportion of positive and negative surprises was roughly equal. In other words, it was roughly a 50/50 chance that an earnings report would produce a positive or negative surprise. Although the proportion of positive surprises decreased during the current recession, it hardly fell below 60% let alone reverted back to the old 50%/50%. This has been the worst profits recession on record, but still more than 60% of the S&P 500 companies produced positive surprises. Something certainly seems odd.
The primary catalyst behind the secular increase in positive earnings surprises has been the on-going development of more sophisticated investor relations techniques. In the 1990s, I spoke at several conferences for investor relations officers on the specific topic of earnings surprises and stock price reaction. Little did I realise at the time that my insights regarding earnings surprises, stock volatility, and their detrimental effects regarding corporations’ long-term cost of capital and growth potential would be used manipulate investors’ expectations rather than for better management of the underlying businesses.
The increased use of non-GAAP reporting has also led to the growing trend in positive earnings surprises. The primary purpose of GAAP accounting is to provide investors with consistent information across companies and, equally as important, across time for a single company. Accountants do not verify non-GAAP data, so “adjusted earnings”, “non-GAAP earnings”, or “earnings after certain items” are all synonyms for “fictitious unaudited” earnings.” If a company is going to fabricate their earnings, then it should be no shock that they tend to disclose earnings figures that are higher rather than lower. I have questioned for years why the SEC allows non-GAAP reporting because there is absolutely no aspect of non-GAAP reporting that is in investors’ best interests.
Positive surprises have, therefore, become relatively meaningless as a source of fundamental information. Negative surprises, however, still have significant investment information. In fact, negative surprises may be more important than they have historically been because of the trends described. A negative earnings surprise signals to investors that a company could not control investors’ expectations despite the company’s best efforts. In other words, they set a very low hurdle in hope of producing a positive surprise, but still stumbled. A negative surprise suggests that a company’s business is completely out of control.
This quarter, so far, has produced an increased number of positive surprises. The business environment is stabilizing, but not because fundamentals are improving. It is stabilizing because companies are regaining control over their businesses to the extent that they can again manipulate investors’ expectations. One needn’t belittle a definite positive, but one also needs to fully appreciate the underlying behaviour.
In addition, few observers have discussed the potential political consequences to a cyclical upturn in positive surprises. Corporate profits as a per cent of national income was the highest in the post-war era going into this recession. The last cycle was one in which the corporate sector’s wealth increased dramatically relative to that of the household sector. Within that historical context, it may be a good assumption that legislated corporate tax rates could increase if there is a continued increase in positive earnings surprises without a generally recognised stabilisation in employment.
The fact that companies are regaining control over their operations is indeed a very good sign, and supports my earlier contentions that investors should be normally weighted in equities. However, investors need to remember that the quarterly earnings reporting season is just a charade, and could bring unwelcomed attention from Washington.
Richard Bernstein is CEO of Richard Bernstein Capital Management, LLC. He was previously Chief Investment Strategist at Merrill Lynch.
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