To Be, or Not to Be…Surprised

Earnings season is in full swing. This is the time each quarter when analysts and investors hear from company management regarding the past three months and gauge what that means for the future. Stock prices move based on how the company’s performance is viewed against what was expected. How financial results are judged relative to expectations provides insight into a behavioral anomaly that permeates the market.

Jason Zweig, of The Wall Street Journal, recently opined on this quarterly ritual. He appropriately explains the “dance” between company management and the analyst community. In short, there is a mutually beneficial interest between analysts, companies and investors to raise estimates, but not too far whereas the company cannot beat them. When a company ultimately jumps over this artificially low bar, analysts look good as they are forecasting higher profits that prove correct, and company management looks good as they beat a slightly higher bar each quarter. Investors should benefit too, if stock prices rise to reflect the new step-up in expectations as they are “surprised” by the results.

There is also a realization that investors are at least partly aware of this bias in estimates, and thus come to expect a company to beat expectations. If the market was truly efficient, the stock price should already reflect the belief that a company will beat the consensus estimate, and not appreciate based on the eventual positive earnings surprise. However, this is not always the case. The earnings surprise phenomenon continues.

We believe that an earnings miss is more indicative of a company’s fortunes, as it disrupts the delicate dance. If a company announces a negative surprise it would stand to reason that something is materially wrong with the fundamental story since the company was unable to hold up its end of the bargain. Based on this assumption, an increase in the percentage of companies reporting negative surprises would be a sign of broader fundamental issues.

Is the current rate of negative earnings surprises reason for concern?

Within our large cap universe, 11% of companies reported negative earnings surprises for the three months ended June 30th. This rate has been fairly steady going back to June of 2017. In fact, the last five quarters have trended below the long-term average. The story is similar within our small cap universe. The negative surprise rate was 22% as of June. This is also consistent with the prior four quarters and in line with the long-term average.* According to our research, there is currently no indication of rising widespread weakness.

We agree with the environment Zweig describes between analysts, company management, and investors. At 361 Capital, we believe this unspoken interaction between analysts and management and the subsequent response rates by investors are evidence of the behavioral anomalies that exist and can be exploited. Understanding the the dance steps is critical to devising an appropriate strategy.

In a future post, we will look at what consensus represents and how it determines a surprise.

Read more in our latest blog, Earnings Impress, but Wall Street Sentiment Falters >