05 Apr 2002 Earnings Improvement?

Companies will soon begin reporting their fourth quarter earnings to their shareholders and the market will have some real information to digest.  The market, between earnings announcements, is generally influenced more by macro economic, political, and emotional events than it is by the actual earnings performance of the sum of the companies it represents.  Since the SEC enacted Regulation FD (requiring all public companies to make significant and material announcements publicly and broadly) in August of 2001, a certain rhythm has developed.  The ‘dance’ as we shall call it between companies’ managers and analysts, media, and stakeholders actually has three movements. 

The first movement begins a month or two before actual earnings are released.  It is known as the confession period.  Wall Street’s analysts, most of them employed by brokerage firms, regularly announce and update their expectations for individual company earnings throughout the preceding quarter, both within their firm and to companies such as First Call that match the projections with other analysts’ projections and publish them. During the confession period those companies who for various reasons expect to come up short of analysts’ or their own projections make these admissions publicly.  Their stocks usually react negatively on the disappointing news.  The last two years are marked by many such events, but this confession period has been unusually quiet, suggesting better earnings news on the whole.

Those companies who expect to meet or exceed their estimates usually keep quiet, unless an unduly weak stock price compels them to make a positive announcement early.  Most are reluctant to announce good news early for fear that some unexpected event could adversely impact their quarter’s results.  Many company management teams also pride themselves in maintaining a long string of positive earnings surprises, so they will ‘guide’ analysts estimates a bit lower than the results they expect.

The next movement in our ‘dance’ is that of the actual earnings announcements.  We expect those results to start coming in next week.  The final movement of the trilogy sometimes occurs as part of the earnings announcement.  Managers will give shareholders and analysts some idea of what they expect for the quarter or quarters ahead.  They will talk in terms of business conditions and earnings ‘visibility.’  The better their visibility the more upbeat they can be.  However, due to the Enron/Anderson induced climate of distrust and the huge increase in shareholder class action suits alleging improper disclosures, management teams are more guarded than ever in their comments.

This earnings season promises to be better than recent quarters because the economy is showing definite signs of improving.  The last of warnings, mentioned earlier, also strengthens the case that we will see improvement.

Earnings are the basis for determining long-term stock values.  The ‘long-term’ distinction is made because the logic of earnings-based stock valuation often takes a back seat to emotion-driven events.  We have seen countless examples where entire industries are devalued because of one or two bad companies.  The whole utilities industry suffered while the California/FERC debates rolled along, but only certain companies were truly affected in the imbroglio.  General Electric and Tyco dropped significantly in price when journalists and analysts (and some short-sellers) suggested they were hiding significant events in their accounting.  When the facts came out the stock prices began their recovery.

We look further ahead than quarterly data because there are so many unexpected variables affecting those numbers.  By taking a longer view of earnings we can ‘smooth’ out the bumps caused by unexpected events that have little or no long-term impact on the company’s health.  The chart below summarizes Wall Street’s expectations for one-year and the five-year average earnings growth of the companies held in our Quality, Growth, and Aggressive portfolios.

Model Portfolio Earnings and Volatility

Because stock prices are directly impacted by earnings, the rated of earnings growth is highly predictive of future stock prices.  It is important to note that the five-year growth rates reflected above closely relate to the actual average annual returns of these models demonstrated before the interruptions caused by the ‘Internet Bubble’ from 1999 through 2001.

The other side of the sword is volatility, or risk.  For a number of reasons including Regulation FD, 9/11, Enron/Anderson, the Internet Bubble and the Middle East, stocks are much more negatively volatile than in the recent past.  A measure of this volatility is Beta.  Beta compares the individual stock’s volatility to that of the general market.  A beta of 1.5 suggests the individual stock will be 50% more volatile than the general market.  We attempt counter the negative effects of volatility with diversification.  The idea is that when one or a few companies are negatively impacted by market events, others in the portfolio react positively on the same news.  However, during bear markets, the bad news ‘brush’ paints a much broader stroke than it does during a more optimistic times.  We have further tried to mitigate the volatility by increasing the number of companies held in the portfolio.  As the economy improves, volatility is expected to decline.