Why investors shouldn’t listen to analysts’ estimates
We again find ourselves in the land of sunshine and daffodils otherwise known as earnings reporting season.
And a delightful place it is, with about three-fourths of the Standard & Poor’s 500 companies beating analysts’ estimates in the third quarter ended Sept. 30. Investors might look at such a remarkable performance and conclude that it’s time to load the wagon with stocks.
That’s not an unreasonable strategy, except for one teensy-weensy problem: This happens every quarter like clockwork. Wall Street analysts always — and I mean always — make wildly optimistic assumptions about corporate earnings first, only to bring down those estimates as the quarter draws to a close.
This enables companies to beat the lowered expectations. Corporate earnings growth has been virtually nonexistent for the last five quarters, and yet the vast majority of S&P 500 companies can boast of consistently beating estimates.
In fact, actual earnings have beaten analysts’ expectations without fail every period since the second quarter of 2012, according to 720 Global, a Washington, D.C., investment research firm.
“It’s not that analysts are incompetent, because they are bright people,” said Michael Libowitz, founding partner of 720 Global. “But this earnings game is highly suspicious. I just think these firms [that employ analysts] are not looking out for the best interest of small investors.”
Whatever the reason, analysts grossly overestimate corporate earnings starting six months to a year before companies release them, then they gradually lower their estimates. Actual earnings growth in the second quarter of this year was negative 3.4 percent. A year earlier, however, analysts were forecasting earnings growth of 13.7 percent, according to 720 Global.
Similarly, the quarter just ended will have earnings growth of 2.9 percent, but a year ago, the estimate was 7.1 percent, according to FactSet Research Systems Inc. As the quarter closed estimates came down, allowing 71 percent of the companies in the S&P 500 to beat expectations.
“Over the last 17 quarters, the best one-year advance estimate of earnings growth was overstated by 25 percent,” Libowitz said. “The same analysts that peddled double-digit earnings growth a year earlier somehow can now claim that earnings are better than they expected.”
Over the years, numerous academic studies and market research reports have shown that analysts’ estimates are consistently 30 percent to 40 percent off the mark. John Mauldin, chairman of Dallas-based Mauldin Economics, described earnings season as a “giant expectations shell game.”
The wildly optimistic estimates encourage people to buy stocks, and then revisions convince investors not to sell because companies are beating expectations.
“I don’t think this phenomenon is the result of some nefarious conspiracy,” Mauldin wrote in a recent report, “but it might as well be. It is the fault of both company management and willing analysts responding to incentives before them.”
It’s difficult to know why analysts so consistently miss the mark. But in their defense, the companies they cover don’t always provide accurate guidance and information. Increasingly, companies manipulate their earnings with all manner of one-time charges and special write-offs using so-called pro forma financial statements.
After the Enron and WorldCom scandals of the early 2000s, Congress passed the Sarbanes-Oxley Act in July 2002. Its purpose was to protect investors from accounting fraud and improve financial disclosures, meaning everyone gets the information at the same time.
But a Bloomberg study last year showed that the crackdown on Wall Street has been woefully inadequate if the goal was to improve financial reporting. The new rules should have produced better company research, but the study revealed that analysts missed their targets by an even greater margin after Sarbanes-Oxley.
The Bloomberg study found that between 2000 and 2013, analysts’ projections missed the actual results by 35 percent compared with 33 percent before Sarbanes-Oxley. The study blamed substandard financial statements as the culprit.
The bottom line for small investors is to take analysts’ buy-and-sell recommendations and forecasts with a grain of salt. Often analysts put buy recommendations on stocks after their prices have already spiked. And sell recommendations often arrive much too late to be of benefit.
At the start of 2015, consensus estimates for the total earnings per share of all S&P 500 companies was $137, but by the end of the year actual earnings per share were about $100. It’s a similar story this year: Initial estimates started in the $130 range but the current estimate for 2016 has dropped to $118.
Undeterred and with their bullish bias in full flower, analysts first predicted 2017 earnings of $140 but have since taken that down to $132. And they will take down their estimates even further as the year unfolds. It’s a shell game, and everybody knows it — especially the analysts.