6 reasons why Wall Street analysts mis-estimate company earnings

companies continue to beat Wall Street estimates

It’s earnings season again.  As companies report their results for the quarter, investors watch carefully to see whether they match, surpass, or fall short of, the consensus estimates of Wall Street securities analysts.  As has been the case since the bull market began over two years ago, a majority of companies are beating the consensus figures–some by a mile .

Why don’t analysts do a better job of forecasting?   

I have six reasons (five of them today, the final one tomorrow):

1.  Some companies are very hard to forecast, because they’re so complex.  They may have a lot of divisions, many suppliers and a large variety of finished products that they sell.   

Alcoa, the first of the big publicly traded US corporations to report each quarter, is a case in point.  You’d think that the main variable for Alcoa would be the price of aluminum, which you can see every day in commodities trading.  …but no.

Alcoa can get its raw materials from many sources.   Some sources are joint ventures that Alcoa’s a part of, which often have complicated profit-sharing arrangements that are not publicly disclosed.

Miners deliberately change the grade of ore they mine, depending on price, to maximize the life of the ore body.  Ore can be processed in different locations, some company-owned, some not, depending on the price of electric power and other factors.  So expenses are hard to gauge.

On top of all that, differing accounting conventions at each step of the way can play a big role in what cost figures eventually appear on the income statement.

In a case like this, it’s hard to imagine anyone outside the company having a good handle on what reported earnings will be.

2.  Some companies demand that analysts stay close to “official” guidance.  CEOs understand that having earnings per share that exceed the consensus is a good thing for their company’s stock  (a positive earnings surprise), and that missing the consensus can be a very bad thing  (a negative surprise).  So most firms that issue next-quarter guidance to analysts give out numbers they believe they have an excellent chance of beating.

Some firms go further than that.  They make it clear they will punish any analyst who deviates from guidance more than a little bit.

What can a company do?

Lots of bad stuff.  From descending order from worst to not-as-bad, the company can:

–stop using the analyst’s firm for any investment banking services, like underwriting debt or equity offerings (which is likely to get the analyst fired),

–not appear at industry conferences the analyst’s firm may organize, or send the investor relations guy instead of the CEO or CFO,

–avoid using the analyst to organize the company’s visits to powerful investment management companies,

–refuse to give the analyst access to top company officers to ask questions about operations,

–delete the analyst from the queue to ask questions during earnings conference calls (petty, it’s true, but not unusual).

There have been cases of stubborn analysts who have stuck to their guns in print, against company wishes.  Their stories  usually end badly.  For most, they’ll show the number the company wants in their written reports and “whisper” their best guesses to clients.

3.  Some analysts aren’t good with numbers.  That’s not always a fatal flaw.  The analyst may have other pluses–a deep knowledge of the inner workings of an industry, an ability to  sense new trends quickly, or very good contacts with the companies, or customers and suppliers.  Or maybe they just know where to take clients to lunch.  After all, when you get down to it, sell-side analysts are paid for their ability to generate commission business  for their trading desks and to attract/keep investment banking clients–not necessarily for having the best numbers.

4.  Sometimes analysts don’t do the spreadsheets themselves.  An assistant does them instead.  Analysts may spend half their time on the road visiting companies and clients.  Much of the rest of the time, they’re doing the same thing on the phone.  And the analyst may not be so great with numbers, anyway.  So that task is relegated to an assistant.

An aside about assistants:  in my experience, many analysts pick assistants who are articulate, look good in a suit and are smart–but not too smart.  Why?  A sell-side analyst may earn 10x-20x what an assistant does, in an industry that suffers a severe downturn in profits about twice a decade.  The analyst may worry that having a top-notch assistant means the analyst becomes a cost-cutting victim during recession.

5.  Many experienced analysts have been laid off over the past few years.  Doing good estimates doesn’t require a genius, but it does require some training and experience.  A lot of that has been lost on the sell sidesince the Great Recession began.  In addition, as I suggested above, the assistants who have been promoted into the principal analyst jobs may not all be the brightest crayons.

That’s it for today.  I’ll write about #6, making really dumb mistakes, tomorrow.

what’s wrong with a balanced budget amendment?

a balanced budget amendment to the Constitution proposed

Over the weekend, Republican Senator Orrin Hatch of Utah, aware of the possible threat from the Tea Party to his reelection, proposed that the US should “solve” its budget deficit woes by passing a constitutional amendment ordering Congress to maintain a balanced Federal budget.

The idea has some initially plausibility.  After all, politicians of all stripes think they get reelected by delivering benefits to potential voters.  The bigger the largesse, the more certain the election victory.  How to pay for them is only a secondary consideration.  So there’s a natural tendency for Washington to provide benefits to constituents before/without figuring out how to fund them.  A balanced budget amendment is supposed to close the door on this tactic by forcing Congress to find the money to pay for new programs before enacting them.

Optimistic supporters of the idea also argue it will end waste and corruption in Washington, since there would be less potential for loose money to be floating around.  The idea of a balanced budget also appeals to a kind of reverse NIMBY feeling–the idea that others are somehow getting a bigger slice of the Washington pie and that a better accounting for expenditures would put an end to that.

The basic positives of the balanced budget idea are supposed to be:

–no more chronic deficits threatening the nation’s financial health, and

–politicians could blame higher taxes/lower benefits on the requirements of the new constitutional amendment, so they’d be more likely to enact them.

one fly in the ointment

Modern economics came into being after, and because of, the Great Depression of the 1930s.  Much of economists’ efforts since have been devoted to understanding what went wrong back then, and in devising was of preventing the Depression from ever happening again.

Perhaps the most basic lesson learned is that contractionary fiscal or monetary policy in an economic downturn just makes things worse.  This bad policy comes in two flavors:

–voluntary contraction, when, as they did in the Thirties, governments raise interest rates as a way of nursing an economy back to health.  This is sort of like the old medical practice of bloodletting that was supposed to cure you by freeing the body of bad humors.

–involuntary contraction.  When economic activity slows, so too does the flow of tax revenue to governments.  In fact, because income taxes are typically progresssive (meaning that added amounts of income are taxed at rising rates), in this situation government revenue falls faster than income does.  If government wants to spend no more than it takes in during a given year, the falloff in tax revenue means it has to lower transfer payments and lay government workers off.  That makes the downturn worse, not better.

the orthodox solution

Based on the terrible experience of the Depression (for example, 25%+ unemployment), economists began to realize that the better course of action is countercyclical government policy–that is, lowering interest rates and increasing net government spending, despite the decreased flow of revenues.  Doing so makes the downturn shorter and shallower.

In an ideal world, a government would also generate a surplus in boom times with which to fund the extra outlays during recession.

another one

For the idea of countercyclical policy to work, government must have enough resolve and foresight to “take away the punchbowl,” that is, to remove the extra stimulus, once the economy is expanding again.  That’s harder to do than it seems.  The George W. Bush administration, for example, started off with a government surplus but increased spending enough to turn that into a big deficit in less than a decade.  In hindsight, the career of the “Maestro,” Alan Greenspan, as head of the Federal Reserve can also be seen as a long series of failures to restore the status quo ante after crises.

the lesser of two evils?

It seems to me that the (unmade, but) most persuasive argument in favor of a balanced budget amendment is that–unlike the cases of Germany or the ECB–in the hands of Washington, countercyclical policy has become just another boondoggle.  Yes, the policy is sound, but Washington just can’t be trusted to implement it.

what about external shocks?

In my career, there have been three:  the oil shocks of 1973-74 and 1978-80, and the financial collapse of 2007.  One might add the stock market collapse of 1987 to the group, although it would have been the runt of the litter.  Both 1973-74 and 2007 have invited comparison with the early days of the Great Depression.

These downturns were so unusual and so severe that simply deciding to wait them out would have been a very poor option.  In 2007, which should be the freshest in memory, global commerce was frozen, brought to a halt by worries about bank solvency.  Money market funds, which supply short-term finance for industry, were on the verge of collapse.  Citigroup, among other banks, were about to become bankrupt.  Businesses were beginning layoffs on a truly massive scale.  A replay of the 1930s was staring the world in the face.

Luckily, the world understood the appropriate response and implemented it (in the two most important countries, China and the US, at least)–although the US stock market dropped by 7% when Republicans (inexplicably) refused to vote in favor of countercyclical stimulus–making matters that much more urgent.

like the gold standard

Advocates of a literal gold standard seem to me not to know what that means–or to be unaware of the example of the California gold rush that produced massive, destabilizing inflation in the US.  That’s why the gold standard is a rallying cry for monetary regimes which, when you examine the details, are anything but.  (See my posts on gold and the Gold Standard.)

I view calls for a Federal balanced budget amendment in a similar vein.  They’re rallying cries for fiscal programs that have got to have safety valves to address unusual situations–and therefore aren’t really mandating true budget balancing.

I think most Americans think the real solution to Washington’s dysfunction is systematic reform.  That’s what the country thought it was getting with Mr. Obama.

What is a “special situation” stock?

special situations

I was reading in the Financial Times earlier today that the China Special Situations fund has not been doing particularly well lately and decided I’d write about it.  The closed-end offering, Fidelity sponsors, is traded on the London Stock Exchange and run by Anthony Bolton, a portfolio manager who made his reputation through his long tenure with Fidelity’s UK-oriented special situations fund.

Before I do, I realized I should write something about what a “special situation” is and how it differs from a run-of-the-mill growth or value stock.

what they are

To my mind, a special situation stock is one that:

–offers the possibility of very high absolute returns, where

–returns will be based on factors that are specific to one firm or a small group of firms, and

–where understanding the relevant factors requires a lot of specific company knowledge (and not just awareness of general industry or macroeconomic developments, or of the general information contained in the financial statements).

Many times a special situation stock is relatively small and has few analysts following it.  Sometimes, returns are dependent on the occurrence of specific events.

risks

Generally, special situations have a lot of stock-specific risk.  The event may not happen.  The detailed securities analysis may be incomplete or wrong.  New competition may appear from out of the blue.

Examples:

–a company may have privileged access to an essential raw material that is about to come into shortage.  Rare earths might be a current instance.

–a firm may own key intellectual property, like patents or copyrights.  At one time, the Japanese company Pioneer was one of two companies that held basic patents for CD players.  For many years, royalties from this patent (now expired) exceeded 100% of the company’s net income.  In another country, that fact would have invited takeover or management-led restructuring.

–a company may have two divisions, one that makes money and one that has losses.  By allowing investors to see the performance of each separately, with, say, growth investors bidding up one part and value investors the other, breaking the company apart may unlock value.

–a firm may be a likely takeover target, at a stock price that would be a large premium to the prevailing level. 

–Merger and acquisition investing involving companies already being bid for–on the idea that the final bid price will be significantly higher than the market now realizes–is a narrower form of this.

–a company may have significant off-balance sheet assets, such as big potential/realized tax losses, or unproved mineral reserves, whose value isn’t well-understood.

–a company may be developing a revolutionary new product that’s big enough to make a dramatic difference to company profits, as Apple was with the iPod or the iPhone a half-decade ago, or Monsanto was with genetically modified seeds at around the same time.

what they aren’t

–well-known

–dependent on general macroeconomic forces

–easy to figure out.

That’s it for today.  China Special Situations on Sunday.

 

 

 

 

systematically important banks: BIS says “No, no!” to co-cos

the BIS and “too big to fail”

The Bank for International Settlements, the unofficial rule setter for the world’s commercial banks, is in the process of making new guidelines to govern the behavior of systematically important (read: really big, or “too big to fail”) banks.

extra capital needed…

A couple of days ago it aired new regulations that would force the biggest banks to hold more capital to back a given loan than a smaller bank would need.  The bigger the bank, the more capital necessary.  And if a jumbo bank tried to become jumbo-er by adding net new loans, it would need even a higher level capital to back those.

The thrust of the rules is to create economic incentives for banks not to get bigger, or even to break themselves up into pieces, so that the potential failure of  one massive bank would no longer threaten to bring down a country’s entire financial system.

…through co-cos?  No, thank you.

During the discussion, the question arose as to whether the BIS would allow this “extra” capital to be supplied, not just by equity, but by  convertible securities (co-cos) as well.  The BIS said no.

why not

It didn’t supply reasons, but I think it’s easy to see why (before I go any further, I should warn you that I’m not a fan of gimmicky securities like co-cos, as you can see from this older post.  I may have gotten a little carried away when I was writing it, but I still believe what I wrote then.):

bondholders and stockholders have different points of view about the issuers of the securities they own.  The former care mostly about collecting their coupon payments and getting their principal returned at the end of the bond’s life.  Shareholders want healthy growth of the enterprise, so that they get a higher stock price and greater dividend payments.  Shareholders tend to make waves; except in extreme situations, bondholders don’t.

If the idea of the extra capital is to have more people with a strong interest in preventing aggressive expansion of the loan book, you probably want to increase the number of professional equity investors with an interest in the bank, not replace them with bond fund managers.

no one knows how contingent convertibles will work in a crisis.  In particular, if the conversion provisions of a co-co are triggered and the security becomes an equity, bond managers who own it (and whose contracts with customers doubtless bar them from holding stocks) will be forced to sell.  Having lots of stock in a troubled company being dumped on the market and forcing the price down probably won’t make the bank’s situation any better.  If it prevents the firm from raising new equity, it could make things considerably worse.

a flaw in the terms of existing co-cos has been detected. Commercial banks and their investment bankers want the co-co conversion trigger to be based, as is the Lloyds TSB issue I wrote about in my original post, on the level of equity shown in the bank’s accounting statements.  We’re currently seeing in the EU financial crisis an example of the extreme unwillingness of governments and politically connected banks to write down the value of impaired assets (in this case, Greek government bonds).  But it’s the process of loan writedown that forces the co-co conversion into new equity.

In other words, in a future crisis, governments may not permit their banks to acknowledge that their capital is impaired.  So the conversion of co-cos may never be allowed to take place–meaning that the institutions will be seen to be even more leveraged than thought.

 

 

 

reducing government debt: the Carmen Reinhart cookbook (I)

“The Liquidation of Government Debt”

Over the Memorial Day weekend, I was catching up on my reading–including some back issues of the Financial Times that I just hadn’t gotten to in recent weeks.  That’s how I found out that Gillian Tett had written an article on May 10th, titled”Policymakers learn a new and alarming catchphrase.” 

The article calls attention to recent research by Carmen Reinhart (of This Time is Different; Eight Centuries of Financial Folly fame) and M. Belen Sbrancia, called “The Liquidation of Government Debt.”  Ms. Tett says the work is getting a lot of attention in Washington.  The paper is simultaneously a history of government strategies for reducing excessive debt, accumulated in the developed world mostly as a result of world wars.  More importantly, it also serves as a recipe book of sorts for the US and the EU to do so again today to shrink the liabilities created in the financial crisis.

opening points

Ms. Reinhart makes two opening points:

1.  As a percentage of GDP, the current surge in government debt in advanced economies, which stems from what she calls the Second Great Contraction, is stunningly large.  It dwarfs what was accumulated during the Great Depression.  It also exceeds the amounts amassed in fighting World War II.  (Alone, checking out the chart she uses to illustrate this is worth downloading the article for.)

2.  Growing out of debt of this magnitude is highly unlikely.  This is at least partly because the large debt burden itself acts to slow economic growth.  Yes, the popular myth is that the US grew out from under its WWII debt, but it didn’t happen that way.

shrinking post WWII debt:  “financial repression”

How did the US free itself from WWII liabilities?  …through “financial repression.”   Basically, this means the government of a country engineers a situation of:

–negative real interest rates and

–forced investor purchase of government bonds,

–over a very long period of time.

In the post-WWII US, which implemented such a regime, the country reduced its outstanding debt at the rate of 3%-4% of GDP yearly–suggesting “financial repression” would have to remain in place of at the very least ten years to get government borrowings under control.

two elements to financial repression

Financial repression has two elements:

1.  ceilings on nominal interest rates.  This would mean caps on the interest that banks or other financial intermediaries could pay to savers, as well as ceilings on the rates at which they could lend, either to all borrowers or at least to the government.

2.  forced lending to the government, including:

–capital controls to prevent money from leaving the country for more lucrative investments elsewhere, making government securities more attractive by default,

–high bank reserve requirements, i.e., mandated low- or no-cost loans to the government,

–“prudential” regulatory requirements that institutional investors–insurance companies, pensions funds, bond mutual funds–hold significant amounts of government debt in their portfolios.

financial repression is politically attractive…

As Ms. Reinhart points out, what makes financial repression especially attractive to politicians is its “steath” nature.  Unlike increases in taxes or cuts in government programs, it leaves no fingerprints that can be traced back to individual officeholders and foil their reelection chances.  Imagine trying to explain what’s going on in an election speech without having your listeners’ eyes glaze over.

…but very bad for bond returns

The bottom line:  in its simplest terms, financial repression is a hidden tax on bonds that could be in place for ten or twenty years.  From an investor’s point of view, having the government do this–and it might be the easiest choice for Washington–would return bonds to being the unattractive holdings they were in the pre-Volcker years.  No wonder bond fund managers are beginning to squawk.

Tomorrow, the effect of  financial repression on stocks.