Trading stocks during earnings season, now in full swing in the United States, is a treacherous business. Learn why it's easier to profit by buying shares in female- or foreign-led companies; why savvy investors pay attention to managers' tone; and why earnings season is really cheating season, with companies playing all kinds of games in order to shape stock prices.
Analysts: male, white and American
Most analysts in the US are male, white and American. They are also more likely to vote Republican. Does this matter?
Yes. Decades of research shows people are more likely to hold favourable opinions about members of their own group, and it turns out analysts are no different. A recent study, In-Group Bias in Financial Markets, finds that male analysts provide lower earnings estimates and worse stock recommendations for companies headed by women.
Similarly, American analysts are more likely to be dubious about firms with foreign chief executives. The same goes for Republican analysts covering firms with a Democratic chief executive.
Consequently, they tend to be too pessimistic about firms where the person at the helm is a woman, foreign or a Democrat. As a result, such firms are more likely to beat profits expectations and enjoy a postearnings share price pop.
Managers’ tone matters
What chief executives say about earnings is important, but so is how they say it, according to a 2015 study, Reading Managerial Tone: How Analysts and the Market Respond to Conference Calls. The authors found the tone used by managers during conference calls predicts future earnings and uncertainty.
Good news travels faster, with stock prices responding more quickly to “tone delight” rather than “tone disappointment”. However, a surprisingly negative tone is actually more predictive of the stock price’s future direction, signalling that further bad news can be expected in coming months. The results indicate managers “leak information, whether purposefully or inadvertently”, the authors note.
A more recent study by the same researchers finds that managerial communication style is also important when it comes to deciphering earnings information. While some executives are straight talkers, others are vague, routinely using words like “probably”, “approximately” or “maybe”. Unsurprisingly, stock prices and analysts are slower to respond when communication is vague. However, if this vagueness is an attempt to fool investors, it fails – companies with vague managers are punished with lower valuations.
‘Cheating season’
Every quarter, commentators fret as to whether the world’s biggest companies will miss, meet or beat analysts’ earnings expectations. Most of the time, they deliver an earnings beat – usually, around two-thirds of companies beat expectations. Even at the very height of the global financial crisis in late 2008 and early 2009, between 59 and 66 per cent of US companies beat expectations.
Earnings season is really "cheating season", a "charade", as Société Générale's Andrew Lapthorne once put it. Almost invariably, the process begins with analysts providing excessively optimistic estimates of what companies will earn over future quarters. Companies then "walk down" these estimates, lowering estimates over time. By the time earnings season comes around, expectations have been substantially watered down. Companies then beat low-balled estimates; everyone cheers, including the analysts, who can boast to clients that their final estimate was conservative, but relatively accurate.
Although everyone knows how the game is played, market prices are nevertheless affected by these shenanigans. The S&P 500 is much more likely to rise in busy reporting weeks compared to the quietest weeks, according to Lapthorne’s data. His conclusion? “Don’t be short during US reporting seasons.”
Manipulation
Most executives downplay earnings expectations because they feel obliged to participate in the aforementioned “underpromise and overdeliver” ritual, but others may do so for a less defensible reason – to manipulate the stock downwards so that they can buy it cheap.
Companies provide guidance for the upcoming quarter in postearnings conference calls. By the time earnings are announced, the next reporting period is already well under way; consequently, they should have a fair idea of how things are going.
In a recent study, researchers developed real-time proxies of corporate sales by using data from millions of mobile phones and other electronic consumer devices. The real-time corporate sales indicator they developed was a “powerful” one that successfully predicted quarterly sales growth and earnings surprises.
However, the researchers found that, although their indicator was an accurate one, it was often at odds with official company guidance. Guidance tended to be “more pessimistic when managers have positive postquarter information”, with executives using language that points “in the opposite direction”.
Crucially, this effect is more pronounced when management insiders subsequently trade company stock. The only “coherent” explanation is one of “managerial manipulation for personal gain”.
One in five misrepresent earnings
Quarterly earnings reports are often untrustworthy affairs, judging by one award-winning study that surveyed 375 chief financial officers (CFOs).
CFOs believe that, in any given year, one in five companies – a “remarkable” number – intentionally misrepresent their earnings. Increasingly complicated accounting rules mean this is “difficult for outsiders to detect”.
This misrepresentation is typically not a minor affair, accounting for around 10 per cent of total earnings. Most of the time, companies overstate earnings, although they deliberately low-ball earnings in one-third of cases.
Why? The explanations are unsurprising: “A desire to influence the stock price, related internal and external pressures to hit earnings targets, and executive compensation and career concerns.”
Short-termism?
Do companies sacrifice long-term growth to hit quarterly targets? In a word, yes. In one survey of more than 400 CFOs, almost 80 per cent admitted they would sacrifice economic value in order to meet quarterly expectations.
One common way of temporarily supporting a company’s share price is via share buybacks. Buying back company shares reduces the number of shares outstanding, thereby artificially boosting earnings per share (EPS).
There are perfectly good reasons why companies buy back shares, but it’s worth noting that research confirms they are much more common in periods where companies would otherwise miss EPS targets.
Investors should be be wary of short-termist companies. In one study, researchers analysed the transcripts of thousands of earnings conference calls, counting words suggesting a short-term emphasis – for example, “next quarter”, “latter half of the year” – and words that evoked a long-term view (“years”, “long run”, etc). The short-termist companies, they found, were more likely to manage earnings, as evidenced by higher discretionary accruals, reporting earnings that barely beat analyst forecasts, and cuts in R&D in years where they met or slightly beat forecasts.
It’s natural that investors will cheer if their company beats analysts’ expectations, but it’s not necessarily a cause for celebration – not if such an earnings beat is dependent on low-balled estimates or on sacrificing long-term value.
