The great investing myth (7): Earnings expectation + share price reaction

Many tend to “read” companies’ earnings on (a) how well they “beat” the analysts’ expectations and “raise” their guidance and (b) the share price action after their earnings to conclude how well the companies fare. The estimates consist of revenue, profits and outlook. Usually, it is not an all-hits or all-misses situation that can be confusing. Investors end up shortcutting their understanding of the quality of the earnings to just the initial share price reaction; indirectly embracing the efficient market hypothesis where share prices reflect all information.

A typical chat with a retail investor can be:
Question: How were the earnings for Company X?
Response: Not good, the share price dropped 7%.

Photo by Jan Tinneberg on Unsplash

Taking a snapshot and missing the full picture

Focusing on the company’s ability to meet and raise earnings is akin to taking a snapshot and may not be representative of the company’s progress and long-term prospects. Example: A company may be expected to grow its revenue by 25% for the quarter though the actual growth rate come in at 23%. The market focus on a miss (and the share price reaction) instead of the company’s achievement of actual growth of 23% (which many may not be aware of) as well as its business progress and operating and financial metrics (double emphasis that many do not delve into). Over time, the company may be growing at 20% annually and we realise that the share price has caught up with the company’s performance. We take a snapshot and miss the full picture.

Our confidence in the companies will just ebb and flow with how their ability to beat and raise and their price action. However, the initial price reaction can be heavily influenced by the market’s sentiment of the day. The market is more forgiving when it is bullish and punishing when it is bearish.

Few delve deeper into the analysis of the earnings report, the financial statements and the earnings call transcript and compare it with its competitors. We are not updating ourselves about the company and its long-term prospects vis-a-vis its operating industry. Unless we are short-term traders, we are following the market with a herd mentality instead of having an independent and long-term investing thesis of the companies.

To add, even the best-performing companies do not always beat estimates. There will be misses as well. Despite their misses, possible pessimism and that this time is different, as we look back, many went on to achieve good returns and some went on to become multi-baggers. Because they still continue to grow at a consistent rate that may not meet expectations at times and many do not track their growth and progress over the long term.

Efficient market hypothesis

Do share prices reflect all information (efficient market hypothesis)? The share price reaction may not exactly correlate to its earnings and its deviation from expectations. It depends on the market’s sentiment during the period. If we believe in the efficient market hypothesis, consistent alpha generation is impossible; making stock-picking a losing game and fundamental or technical analysis irrelevant. Any advantage in the market is therefore derived solely from insider information.

I’m convinced that there is much inefficiency in the market. These Graham-and-Doddsville investors have successfully exploited gaps between price and value. When the price of a stock can be influenced by a “herd” on Wall Street with prices set at the margin by the most emotional person, or the greediest person, or the most depressed person, it is hard to argue that the market always prices rationally. In fact, market prices are frequently nonsensical.”

Warren Buffett

People are ruled by emotion and are not always rational.  George Soros believes that “what beliefs do is alter facts”He calls this “reflexivity,” similar to a feedback loop or an echo chamber.

I believe that market prices are always wrong in the sense that they present a biased view of the future. But distortion works in both directions: not only do market participants operate with a bias, but their bias can also influence the course of events. This may create the impression that markets anticipate future developments correctly , but in fact it is not present expectations that correspond to future events but future events that are shaped by present expectations. The participants perceptions are inherently flawed, and there is a two-way connection between flawed perceptions and the actual course of events, which results in a lack of correspondence between the two. I call this two-way connection “reflexivity”.

George Soros

Some market participants rely on others for analysis, some look at share prices as the reflection of the earnings, some delve to do first-hand analysis, some use charts and some react to emotions in their investing decisions. Hence, there are gaps between share prices and their possible values.

When there is a plunge in share price after earnings, investors can become reactive; panic and be more inclined to sell or hold it hoping for the better. It could be a case of the company’s deteriorating competitiveness and we should exit from the investments. Sometimes, it could be due to tough luck, abrupt changing situations, the company working on a longer-term plan and sacrificing short-term performance resulting in a blip that we may consider adding. Acquisitions and aggressive reinvestments are often not viewed favourably by the market and analysts, especially during the down cycle.

As investors, we need to study the earnings to evaluate whether (a) their moat is strengthening or weakening, (b) the long-term prospects are still good with their current position in the operating environment and (c) any concerns that need to keep a lookout for in their subsequent few earnings. These will help to ascertain whether the current earnings miss is temporary in their rise or the start of their fall.

Good references:
McKinsey & Company: Avoiding the consensus-earnings trap
1988 Berkshire Hathaway’s letter to shareholders (on the efficient market hypothesis)
‘The Market Is Always Wrong’: In Defense Of Inefficiency