Editor's Note: This is a brief excerpt from a recent institutional research note entitled "Investing in the Intangible Economy" by Neil Howe. For information on how to subscribe to our institutional research email sales@hedgeye.com.
Let’s now zoom out and focus on the broader picture. What could possibly explain why earnings growth no longer guarantees above-market return?
The “earnings game” rewards smooth talkers, not outperformers. One reason that earnings are losing their predictive power could be that the numbers presented in quarterly earnings report are no longer truly indicative of a company’s performance. Indeed, an earnings beat increasingly reflects a proactive IR department rather than an outperforming firm.
It’s no accident that, according to a 2016 analysis by The Wall Street Journal, around 75% of S&P 500 firms meet or exceed earnings forecasts. This ratio remains constant quarter after quarter, in good economic times and bad. How is this possible? Because companies have become proficient at ensuring that analysts aren’t overly bullish in their projections. Nearly 2,000 times from Q1 2013 to Q1 2016, according to the Journal, companies would have fallen short of the average earnings forecast if analysts hadn’t changed their figures in the 40 days ahead of the quarterly earnings release.
Negative guidance positions the company to communicate to investors (a) that we are realistic about today and (b) that we are optimistic about the future. Not only did we post an earnings beat, but we expect a huge growth figure in the next quarter. There may have been a time when this tactic was novel and inspired confidence in shareholders. But as the formula has been copied and rolled out marketwide, most analysts have clearly learned the game. In other words, the relationship between earnings and the stock market may have weakened simply because cynical investors have learned to disregard an increasingly manipulated earnings season.
The impetus for companies to talk down analysts has never been stronger than it is today. Increasingly, firms are pressured to turn out positive quarterly performance from shareholders who have grown unwilling to stick with underperformers. By the end of 2016, the average holding period for a NYSE-traded stock was just 8.3 months, down from eight years in the 1950s.
