There is a joke thrown around the research world that states analysts have predicted seven of the last three market corrections. Rather than be taken as a sign of incompetence, it highlights the difficulty in predicting stock performance with great accuracy. Yet there is a multibillion-dollar finance industry borne out of the idea that the future is both predictable and measurable.
Reporting Season can often be considered the kiss of death for many stocks as a significant amount of volatility can accompany a freshly published report, causing concern for investors. What amplifies the worry is, despite the result itself looks quite good, we hear the dreaded cries that: ‘it failed to meet expectations’.
What does the term ‘market expectations’? Put simply, the consensus (market) view is the median of all earnings forecasts available from analysts. It is often relied upon as the yardstick by which a company will be held accountable. But as with all forecasting, not all misses are the same. Let’s explore three variables.
1. Priced for perfection
When the share price of a business suddenly tears in a north-easterly direction, it can catch the stock’s respective analyst by surprise. Given that many analysts are required to produce a price target for a stock to base their buy/hold/sell recommendations, they will often play sentiment catch-up with their estimates to more tightly align the new price with their positive view of the business.
If left unabated the stock can inadvertently become ‘priced for perfection’, so when the company delivers a solid result that falls below the lofty expectations of the market (not itself), the price is savaged. As some may say: ‘Buy the rumour, sell the fact’.
Stocks that experienced this phenomenon during August include AGL Energy Limited (AGL) and Computershare Limited (CPU).
2. Fell short
Sometimes analysts get it plain wrong. While it is unusual for them to miss the mark by miles, given the continuous disclosure requirements companies must adhere to, an unexpected impact on the accounts can blind-side the analyst. This will often lead to a re-rate of the business.
To avoid this issue many companies prudently provide earnings guidance to the market in the form of a range rather than a specific number. This is further refined as the company gains clarity on their earnings throughout the year. However, despite their best efforts to temper expectations, if the figure comes in at the lower end of the range, it is still considered a miss and the price typically corrects.
Stocks that fell short this month were Iress Limited (IRE) and Navitas Limited (NVT).
3. As expected but…
One of the more infuriating forms of failing to meet expectations occurs when a company exceeds their previous stated guidance, yet disappoints on their outlook statement.
After delivering a strong result, management will provide guarded statements citing industry issues as reasons to suspect the previous growth rate will not be replicated. While this tactic is used to temper over-inflated expectations, the stock is sold down heavily as the recent result is perceived as yesterday’s news and the outlook statement becomes a new focus.
Two businesses that suffered ‘as expected but…’ were Bluescope Steel Limited (BSL) and Telstra Corporation Limited (TLS).
The one common denominator in all the above is that, other than the price falling, the expectations on the company were not met. Despite the analyst fraternity’s best efforts to predict the future, the reality is they can’t do it with great accuracy, especially when assigning a target price to a company.
Despite this fact, the great irony about many investment strategies is they are heavily reliant on forward estimates and a company living up to expectations.
At Lincoln Stock Doctor we advocate a research process whereby we focus on business quality first. This includes understanding the Financial Health of a company and assessing whether management has delivered for investors in the past. While investors can’t predict the future, we can assess the cold hard facts. Past performance allows us to accomplish this task.
This article is in no way designed to discredit the concept of looking forward in any way, particularly as it is important in determining whether your Financially Healthy, quality business of today will likely remain so into the future. However, our experience is that good things happen to great companies. Therefore, focussing on finding a great company, based on facts, can be a far better use of time than trying to predict an uncertain future.