Earnings are so binary.

Updated: Aug 21, 2019

Earnings season is one of the more thrilling parts of managing money (though I personally don't care for it). It's a brief 3-4 week period beginning shortly after the end of each calendar quarter when the bulk of publicly traded companies file their (unaudited) quarterly business updates with the SEC and make them available to the public for scrutiny and analysis. The problem isn't that companies are fulfilling their regulatory obligations or that their shareholders are getting quarterly (i.e. short-term) updates, it is the way the process has metastasized over the years into a seemingly binary event that caters to short-term speculators and hedge funds who whip stocks around as they chase short-term gains.


The management teams of public companies usually provide "guidance" each quarter, which is their attempt to read the tea leaves and predict how the next 3 months of business will pan out, as well as the rest of the year. On the other side of the table are the scores of Wall Street analysts who spend countless hours building complicated models (i.e. spreadsheets) into which they plug in various assumptions and data points provided by the company management teams in order to derive their formal ratings. The output of the analysts' models then determines if they should recommend their clients buy, hold or (occasionally) sell a given security. And if only the ratings were that simple... The actual ratings from analysts, depending on the firm they represent, include: Recommended List, Focus List, Strong Buy, Buy, Overweight, Accumulate, Neutral, Hold, Equal Weight, Reduce, Sell, and Avoid to name a few.


Earnings season is essentially a dance between the analysts and company management teams. The collective wisdom of the analysts form a "consensus" view which can deviate significantly from company guidance based on their own biases and economic assumptions. Still, any deviation and variance from consensus and from management's prior projections must be explained (which happens in the earnings conference calls subsequent to the earnings release, well after their stocks have started moving.) This is of course a bit frustrating because traders are reacting to a limited snapshot of data (sometimes just headlines) without much qualitative information behind it.


To me, one of the most annoying aspects of earnings releases is the significant pick-up in stock/market volatility as numbers are released. The immediate stock action tests intestinal fortitude. The headlines hit the tape in rapid-fire fashion and before you can even read the first headline, the underlying stock prices are already moving--and moving fast. It's unhealthy that earnings are released and traded on based on such short-term data. Firstly, it focuses investors attention on short-term results relative to a seemingly arbitrary bar which is often completely detached from the long-term trends in a business.) For example, if XYZ company reported revenue growth of 25% and the "Street" was looking for 27%, or if earnings per share came in a penny light of consensus, look out below! Secondly, this obsession with quarterly data incentivizes management teams to chase short-term results over long-term success, or else they watch their stocks get pulverized when they miss the consensus target by even a small amount. Worse, management teams are notorious for "cookie jar accounting" whereby they can pull a few accounting levers, perhaps hold off on some payables or make a few minor adjustments and magically "make the numbers." While these bouts of irrational volatility can certainly be excellent sources of investment opportunities, having to live through them when you already own the stocks can test not only your patience, but it can make you second-guess your entire investment thesis--based on the short-term movement of a stock, not the actual underlying business fundamentals. If you want to know why people often get "shaken-out" of perfectly good stocks, you don't have to look much further than an errant earnings report--even if the business itself and the investment thesis remain completely sound.


As maddening as the earnings volatility can be, that is the way information is processed in today's fast-moving markets. I don't think the markets are "efficient" at getting stock prices correct, but they are certainly quick to respond to information, regardless of how well the new information is understood. It can seem like an exercise in banging ones head against a wall, yet I have participated in this process every quarter for close to 20 years now and it never ceases to make me scratch my head. In today's world, every piece of data is treated as a signal to act with very little effort spent parsing through what is more often than not just noise. It's a shoot first, ask questions later mentality.


This dynamic is exacerbated at best and selfishly promoted at worst, by the financial networks (CNBC) who care most about ratings and push "the trade" to drive viewership. From Fast Money to Mad Money, viewers are bombarded with dozens of stock/ETF tickers pushed by the same roster of guests talking their books, while providing limited bursts of shallow insight, often reducing complex, dynamic companies to a few scribble lines on a chart. Worse, they'll often just look at any given sector ETF to explain why a specific company's fundamentals merit an immediate trading decision. "Trade it or fade it!","Buy, buy, buy!", "Sell, sell, sell!" Hold an investment for more than a year? BORING! "Booyah!"


No thanks. Happy Money and Responsible Money are fine with me. Investing is not a contact sport and speed isn't everything.


Earnings season down-time...


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