Lessons from Wall Street's Quarterly Earnings Obsession

What we can all learn from Wall Street's quarterly earnings obsession

By Suzanne McGee

 

It’s time to break free of the “tyranny” of “quarterly capitalism”, Hillary Clinton proclaimed in an economic stump speech on Friday afternoon at New York University. Translation? The Democratic Party’s front-running presidential candidate is taking aim at Wall Street – sort of.

Clinton is no Bernie Sanders, or Elizabeth Warren for that matter. For some she is, in fact, just a little too close to the money men. So perhaps unsurprisingly, instead of offering a wide-ranging critique of US capitalism, Clinton’s taking aim at a very specific Wall Street ritual: the corporate earnings report.

What makes her comments timely as well as interesting is the fact that they were delivered smack dab in the middle of the second quarter’s “earnings season” – the six-week period during which the vast majority of publicly-traded companies tell us how much money they made during from April 1 until June 30, and analysts and traders rush to compare those figures to forecasts.

When the numbers measure up – or even better, exceed – the forecasts, it’s known as a “beat”, and Good Things Happen. Just look at what happened to Google earlier this month when it delivered better-than-expected results, including an 11% jump in advertising revenue. The company’s stock set off for the stratosphere, soaring 16.3%.

That wasn’t only Google’s single best day in its own history as a public company, but the biggest one-day gain recorded by any public company, ever, as the total value of Google (the number of shares multiplied by the stock price) increased by a record $66.9bn to $478bn. It’s as if Google suddenly gave birth to several giant new businesses, overnight.

Then there’s Amazon, which also startled investors by reporting better-than-expected revenues and by announcing that it actually made money, instead of reporting a loss for the quarter. The stock soared 18%; now Amazon is worth more than Wal-Mart.

But if you disappoint, prepare to be punished; Wall Street is unforgiving. Only in the rather bizarre world of earnings season could a 38% gain in profitability and a 35% increase in iPhone sales be dubbed a “disappointment” by analysts covering Apple. But that’s just what happened, in large part because some had expectations that were even higher , and because the company hinted that the current quarter could prove more lackluster. In a flash, $60bn evaporate from the value of the company’s market capitalization. Ouch.

Trying to deliver quarterly results that are on target, or a “beat”, has long since become a game. Entire teams of analysts are devoted to tracking the process. So, for instance, as I write this, I can tell you that Thomson Reuters I/B/E/S calculates that of the companies in the Standard & Poor’s 500 index, 186, or 37%, have so far announced their results. Of those, 74% have beaten estimates, while 18% have reported earnings that were worse than analysts had anticipated. In a typical quarter (since 1994), 63% of companies beat estimates; in the last four quarters 70% beat estimates.

But – remember that I described this as a game? Heading into reporting season, companies will deliver hints to analysts – hey, your earnings estimate for us is too high; you might want to trim it a bit. They’ll do that throughout the quarter, going back and forth, until by the time the quarter is over, and the earnings are announced, what appears to be a “beat” is actually a figure that is lower than the original forecast. In other words, if analysts hadn’t cut their estimates, that beat would have been a “miss”. Only if you’ve been following the process, and have access to the fluctuating estimates – only if you’re an insider – do you know whether a beat is really a beat, and whether to react with exuberance and excitement.

Then, too, what’s happening on the bottom line often isn’t the full story. Consider toymaker Mattel Corp, which analysts were expecting to report a loss of 4 cents a share. When it actually reported a profit of a penny a share, that should have been good news, right? Wrong. That’s still worse than the company’s profits a year ago, and it was accompanied by an unexpected dip in revenues.

When Hillary Clinton takes aim at “quarterly capitalism”, it’s stuff like that she is thinking of. Well, that, and the antics that go on behind the scenes in corner offices in order for chief financial officers to deliver on the expectations of analysts and the investors who await each quarterly earnings season announcement anxiously.

The critique is an old one, dating back decades. The demand to manage earnings on a quarterly basis frustrates the CEOs themselves, many of whom loathe having to ensure their earnings are squarely on target or incur the wrath of giant activist investors like Carl Icahn or David Einhorn, capable of making their lives a living hell.

And it is a real conundrum. On the one hand, CEOs and their chief financial officers are responsible to their investors; their job is to maximize profits. That’s their fiduciary duty. So an investor who sees a company passing up an opportunity to make money this summer, and hears the CEO arguing next earnings season that he made that choice in order to invest in something that will (hopefully) produce even larger rewards in, say, 2017, might justifiably be annoyed. Many CEOs see that as too risky; they’d like to keep their jobs and keep investors pacified, thank you very much. There’s an equally valid argument that by taking those risks (and deferring today’s profits), CEOs are doing their investors, and the economy as a whole, a greater disservice.

It’s worth noting, incidentally, that two of the companies that have delivered blockbuster “positive surprises” so far this earnings season, Google and Amazon, are both headed by management teams with the ability or willingness to defy Wall Street and march to the sound of their own drummer. Google’s co-founders still control the lion’s share of the company’s voting stock, meaning that they can afford to shrug off grumpy investors, to some extent. Amazon’s Jeff Bezos has made it clear that he’ll tolerate large losses if that’s what it takes to boost revenues and market share – and if investors don’t share his vision, they don’t have to stick around.

Clinton argues that companies that become obsessed with “quarterly capitalism” risk throwing the whole system out of balance by focusing only on the short term. Her admittedly wonkish speech criticized “hit and run” activist shareholders and the “culture of short-term speculation”, even if it was short of specifics on how to address those particular features of Wall Street.

But we don’t have to wait for Clinton – or any other politico – to lead the way. We can choose how we react to earnings releases, or fail to do so, for instance.

Corporate earnings news does matter, but the noise that surrounds it rarely does. Forget about the “beats” and “misses” and focus on the context. What is intriguing about Amazon’s announcement is the fact that the dramatic gain came from the company’s cloud business, rather than the core retail operations with which we’re all familiar. That might give you a lot of food for thought about what this means for other companies offering clients infrastructure web services platforms in the cloud, including Google, Microsoft and even Alibaba. Mattel’s announcement got me thinking about the fact that companies are having to struggle to post higher profits – this could end up being the 16th quarter in a row in which earnings grow at a faster rate than revenues, Thomson Reuters has warned. That means the pressure will be on businesses to keep cutting costs to deliver the earnings that investors expect – including salaries and jobs.

Then, too, it’s always good to monitor earnings announcements for what companies say about what they see coming next. What’s happening in China? Will oil prices bounce back to life? Are they worried about Greece or do they see it as a sideshow? CEOs and their chief financial honchos usually have a conference call with analysts after the release of earnings and that’s when the analysts will grill them about what’s going to happen next. One earnings season is now history, and Wall Street is looking ahead for clues to the next. If you really want to play the insider’s game, so should you, by reading the (publicly available) transcripts.

Wall Street may still write the rules of the earnings season game, but that doesn’t mean we can’t tilt the boards a little bit in our favor, whether by figuring out what’s going on or finding a way to play on our own terms.