“What gentlemen say and what they think are two different things.” Hattie McDaniel to Vivien Leigh in Gone with the Wind
In her first line of Gone with the Wind, Margaret Mitchell famously wrote, “Scarlett O’Hara was not beautiful, but men seldom realized it when caught by her charm…” She may not have been beautiful, but she certainly was well advised. The quote above, delivered by Hattie McDaniel in the role of house servant to Vivien Leigh’s Scarlett, could, I think, apply just as well to the “consensus earnings statements” to which today’s investor should be paying close attention. As we progress through earnings reporting season, it seems a good time to review what earnings expectations are and what they are not. What those who create them are saying and what they are thinking may be two different things.
The bottom-up consensus estimates for S&P Composite earnings are calculated by taking an arithmetic average of sell-side analysts’ published earnings projections for the 500 companies that comprise it. (As, indeed, they would be for any group, index, or average.) Changes in these numbers can be extremely helpful in detecting changes in expectations or sentiment. When compared to price data, they can help place current valuations in an historical context. However, the quirks in their compilation and calculation are often misunderstood and generally misperceived. These can, in my opinion, lessen the sting of minor estimate cuts and reduce the threat of seemingly very high earnings expectations.
Here are three issues to note:
- Not even the authors of the estimates believe everything about them. The analysts do put forward their best beliefs for near-term profits. However, they could be choosing only what they think is the best single point within a range—or they may be making their estimates without much confidence. Such nuances are not picked up in the consensus. Moreover, estimates for the distant future can represent statements of earnings power rather than of most likely earnings results. Without a fixed point from which to calculate (current-year earnings are still estimates), the analysts usually rely on estimated growth rates or targeted profitability measures to reach the “out year” estimate.
- No single individual truly believes the result of the amalgamated estimates. The projections are made by industry analysts who have chosen to specialize in a certain industry area. While it is not fair to say that they are all in love with their coverage universe, I would assume that they’ve found some long-term attraction there. It’s a bit like asking the parents of kindergarteners, on the first day of class, what they think their child’s class rank will be at the end of high school. The teachers and administrators should take the results with a grain of salt—after all, not everyone can be the valedictorian.
- We are surveying the wrong people. Sell-side people make estimates. Buy-side people make stocks go up and down. We should ask the buy side for its opinion. However, to maintain a perceived edge, the buy-side people generally will not tell us their real thoughts and expectations. So we are left with the next best thing. If published expectations seem unreasonably high or low to us, they may also seem so to those who buy and sell stocks in large numbers. Something may be going on in the market that’s not reflected in the numbers.
Keep these issues in mind as earnings reports appear over the next few weeks. So far, they seem generally to have exceeded the “true” expectations. If this trend continues, I believe that stocks can move grudgingly—erratically, but significantly higher—over the course of 2013.