Thursday, June 24, 2010

A Caveat to Earnings Surprise - Guidance Bias

Wall Street likes upside earnings surprises, and the market often rewards companies that deliver them. While positive surprises in earnings are often a good thing, you have to be aware of just what is behind it. For example, a company growing at a slower rate might beat earnings estimates by a wide margin while another company that is actually growing faster fails to produce a big earnings surprise.

The reason could be that the slower-growing company issues conservative guidance to analysts. By being so conservative, the company beats earnings estimates by a wider margin than the company that is actually growing at a faster pace, but which issues guidance that isn’t so conservative.

Perhaps the faster-growing company’s policy is to be as forthcoming as possible—letting the proverbial “cat out of the bag,” so to speak. Because of the different guidance practices, the slower-growing company has the bigger quarterly earnings surprise, even though it may be the inferior growth prospect.

This is where the trap comes in. Wall Street utilizes earnings surprise models as a basis for momentum investing. As a result, the company that’s growing at a slower rate, but which beats estimates by a wider margin, draws attention initially and trades up on the news. This is one of the many caveats that exist in the complicated world of valuation.

Before rushing in right after a rosy ernings report, consider waiting to see how the stock’s price not only reacts to the earnings report, but how well it can hold up and if it can subsequently follow through and emerge from a sound consolidation.
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Mark Minervini
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2 comments:

  1. It all comes down to answering the question - Is the growth already priced by the market. A company might grow its eps by 100% q/q and its stock could still decline if the reproted results don't meet the consensus expectations by wide enough margin. The best performing stocks in any given year are usually the ones that surprise the most. Every surprise plays the role of a catalyst that sends price higher and increase expectations. Many companies are very skillfull in managing the Steet's expectations, which results in several consequitive eps surprises. At some point the market catches up with the company's game and discounts any potential future surprises (aka the best case scenario).

    It is not a secret that most companies are extremely conservative in their guidance. The goal is, even in the worst case scenario, to beat the consensus by at least a small margin of few cents. The companies that have the brave to guide substantially higher are usually led by one of the following incentives:
    1) it is a small, neglected company that is looking for some press attention and the consequential increase in liquidity and coverage
    2) A company that has been reporting multiple consequitive earnings surprises realizes that the only way to impress the market and to boosts its stock price is to guide substantially higher.
    3) A company is so confident in its future results that it is not afraid to guide subtantially higher. It knows that it will still beat its own guidance.

    Certainly market reaction to any perceived catalyst is of utter importance. It reveals the current risk appetite and we all know that in short-term perspective, this is what drives prices.

    ReplyDelete

  2. Mark

    Question on the current market conditions. With distribution day today, what would be your stance for the market now? On the one hand, a lot of leaders are holding up at the logical support areas. On the other hand, market has been got some distribution days in last few days.

    I believe the conditions are tenuous and the market could go either way. But curious to learn how you look at the situation at the moment.

    ReplyDelete

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