Here’s what fund managers are looking for.
How worrisome is it when a company changes a previously published earnings estimate? A missed estimate can be catastrophic to a company’s stock price, so C-suite executives often issue a reforecast if they believe market conditions — or poor performance — will prevent their company from hitting earnings marks. And there are some instances in which a company will revise its estimate upward. That’s usually a happy moment for investors, but not always. Here’s how fund managers filter the news that a company won’t perform as initially promised, for better or worse.
Up or down?
Fund managers don’t usually complain when a company nudges up its estimates for performance for the coming quarter or year-end. One exception is when a company chronically underestimates earnings and thinks it’s outsmarting analysts with regular pleasant surprises. Many multinational companies have been lowballing their guidance, estimating performance conservatively in case foreign markets deteriorate, says Brian Hennessey, portfolio manager at Alpine Woods Capital Investors. “If Wall Street is conditioned to you beating your earnings estimates quarter in and quarter out, they’ll award your stock a higher multiple because the predictability of earnings has a lot to do with multiples,” Hennesey says. “They’ll gradually exceed those estimates in a way that’s sustainable, and it tells Wall Street, ‘Hey, these guys are on top of their business.'”
Downward adjustments trigger a closer look.
Global or glitch?
A company getting dinged along with the rest of the world is to be expected, says Vahap Uysal, associate professor of finance at DePaul University in Chicago. “How are the changes in the context of the whole industry?” he says. Market corrections and currency shifts are two global trends no company can overcome. “When markets are going down, all stocks are punished, even if the fundamentals are still there,” Uysal says.
Rough or smooth?
When companies brace for a drop in earnings, they typically shift some sales and expenses into another quarter, minimizing the effect of the big event. This accounting strategy is called “earnings smoothing,” Uysal says. “They all do it.” He examines fundamentals — sales projections, how the competition is doing and “the factors that generate the most value, like customer satisfaction, supply chain and leverage. Those are the universals,” he says.
Bump or blowout?
“The first thing we ask ourselves is, what caused this change and is this permanent or a timing issue?” says Douglas Burtnick, deputy head of North American equities for Aberdeen Asset Management. He takes a look at the top-line growth projections to get a bead on the trendline. If the adjustment is in reaction to, say, a new competitor beating the company at its own game, chances are that the adjustment is an early indicator of big problems. How will the company rise to the challenge — does it have new products in the pipeline or new strategies to outflank the competition? “That’s why we get to know management teams,” Burtnick says.
Cash or crunch?
For investors reaping dividends from equities, cash flow’s the thing. Hennessey goes straight to the impact to income investors and what the downward adjustment will mean for everyone counting on money from the company. Will management adjust expenses to offset unexpected factors so that the company can keep paying dividends as expected? For growth stocks, analysts focus more on prospects for long-term growth.
Blip or dip?
“Most fund managers and institutional investors have a negative reaction to a lowered estimate,” Hennessey says. Often, trigger-fingered investors will sell as soon as an estimate is lowered, causing a temporary dip in the stock price. Fund managers say that offers a fleeting opportunity to buy at a bargain.
Uysal says smart fund managers seize the chance to buy on dips, and dips are often triggered by disappointing earnings forecasts.
If the earnings estimate change is small and widely viewed as a one-time event, it’s usually dismissed as a fleeting blip that probably won’t change the stock price.
Act or hold back?
A substantial drop in estimates that drives down the price will make a buy-and-hold manager take a close look at the company’s track record and growth trends. That’s especially true when a company usually trades at a high compared to its earnings, and usually has stable cash flow and a predictable business, Hennessey says. When that’s the case, the company “guides the Street well, so there’s a lot of trust,” and a temporary drop offers a rare opportunity to accumulate a significant number of shares, he says.
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