When the consensus is wrong

The basic idea behind growth stock investing is to find a company where earnings will be growing faster than the consensus expects for longer than the consensus expects.

For instance…

An example:  Let’s assume a stock is trading at $20 a share.  It had earnings of $1/share last year and is expected to grow by 15% each of the next few years.  This means that, on consensus expectations, it is trading on 20x historic earnings, 17.4x this year’s earnings, and 15.1x next year’s earnings.  As a crude rule of thumb, one might say that fair value for a stock is to have the price earnings ratio equal to the growth rate on next year’s earnings.  On that measure, the stock is fairly valued.

Let’s say the true earnings growth rate is 40%.  That would mean that our stock is trading at 14x this year’s earnings and 10x next year’s.  That’s about a quarter of what our rule of thumb would imply. Apple is a recent instance of this phenomenon.

How does the market adjust its expectations upward?  Earnings Surprise

The conventional answer is “earnings surprise.”  That is, the company in question reports its quarterly earnings that are better than the consensus estimates of Wall Street analysts.  They may even be not only better than the consensus, but better than the highest analyst estimate.

The stock price goes up, for two reasons.  The first is the reaction to the fact that earnings estimates are too low.  The second is expansion of the p/e multiple to account for a presumed higher trend growth rate.

Not so powerful right now

At one time, (positive) earnings surprise had a significant impact on share price action.  Recent studies, however, seen to show that the effect of above-consensus earnings reports on a stock’s price is much more muted than it once was.  There are at least three reasons for this:

1.  Professional investors today routinely study patterns of analyst earnings estimate revision and subscribe to services that identify analysts whose estimates are unusually accurate.  This means much more price adjustment happens before earnings are reported.

2.  A class of hedge funds has developed whose major stock market focus is on possible surprise in quarterly earnings.  These investors tend to react very quickly when earnings are reported, narrowing the time window in which adjustment takes place.

3.  It has become well-known that certain companies try to “manufacture” earnings surprises by “guiding” analysts to estimate earnings at a level the company is sure to beat.  The “whisper number” is a reaction to this attempt at manipulation.  (See my “whisper number” post.)

Best with mid-sized companies

I’ve always found earnings surprise to be most effective with small or mid-sized companies.  Not only to such firms have more explosive growth potential because of their small size, but they also tend to be less widely followed than their larger counterparts.  Marvel Entertainment or Activision (I own both–I’m starting to trim MVL, though) or Coach are good recent examples.

Making a comeback

I would expect that earnings surprises will begin to have greater impact on stock prices than they have over the past decade.  That’s because the recession has caused both brokerage houses and investment management firms to lay off large numbers of analysts (brokers’ star analysts have been leaving for hedge funds for some years, too).  this will ultimately make the market less efficient.  (See my post on this topic.)

Cost-cutting or revenue growth?

There is a difference between earnings surprises achieved through better than expected sales and those achieved through cost cutting, as is the case with many companies in the current quarter.  In both cases, the stock prices should adjust up, from the new perception that the level of a company’s earnings is higher than thought.

In most cases, however, there is a clear limit to a company’s cost cutting opportunities.   If, for example, a retail chain can see that 5% of its stores are unprofitable, it may take a year to close them.  During that time, earnings growth will be enhanced by the elimination of loss making outlets.  But these closing will be over in, say, a year–after which the rate of earnings growth will decline to a more sustainable level.  In a case like this, there is unlikely to be the second positive effect on the stock price from price earnings multiple expansion.

The case of positive earnings surprise from revenue growth–the introduction of a new product, for example–typically produces both positive effects on stock price.  A new product rollout may take several years.  In addition, the appearance of one new product tends to increase investor confidence that more new products, each producing its own positive earnings effect, will follow.