Winning Investors Over. Baruch Lev
in ten days, and continued its ascent thereafter. The reasons for this were solid business conditions and sustained efficiency improvements. The increased demand for Caterpillar’s products post-Hurricane Katrina didn’t hurt either. The lesson is that even a serious consensus miss is a nonevent (except to panicky investors) when the business fundamentals are solid.
GOOGLE’S FIRST DISAPPOINTMENT. Since its 2004 IPO at $80 a share, Google released an uninterrupted stream of good news and received investors’ adulation, catapulting its stock price to $470 in early 2006. Then, on February 1, 2006, came the first reality check. Google released a fourth-quarter 2005 EPS of $1.54 against the consensus estimate of $1.76. Google’s price dropped 8.5 percent (S&P 500 decreased by less than 1 percent) and stayed flat throughout February and March 2006. The intriguing feature here is that Google may have avoided the sharp price drop with an earnings guidance, which the company declines to give, on principle. In a repeat performance, Google announced a January 31, 2008, fourth-quarter EPS of $4.43, a penny short of the consensus estimate, and its price dropped 8.6 percent (S&P 500 rose 1.2 percent).
GOOD NEWS FOR A CHANGE—WILLIAMS-SONOMA’S ONE-PENNY BEAT. Enough with the gloom and on to the rewards of making the numbers, such as this home furnishing retailer that released, on August 23, 2005, a second-quarter EPS of $.26, beating the consensus estimate by a penny. These earnings, moreover, increased by 11.6 percent from a year earlier. Surely good news, although not for shareholders, who reacted with a yawn—a price drop of 1.2 percent (S&P 500 decreased 1.0 percent). The presumed reason was that revenues, which increased 13 percent to $776 million from a year earlier, fell short of analysts’ forecasts of $783 million. The lesson is that it’s obviously not just “the earnings consensus, stupid”; revenue hits or misses matter too.10
GENERAL MOTORS ROARS TO … A PRICE DROP. On October 25, 2006, GM announced, for a change, a profit of $.93 a share (excluding one-time items) against a $.49 consensus estimate. Revenues also topped the forecast. Delirious investors drove the price down 5.1 percent (S&P 500 was up almost 1.0 percent). While never at a loss for “Monday morning” explanations, analysts interviewed by CNN appeared puzzled. The best they could offer was that the CFO’s answer to a question about GM’s profit outlook was: “I can’t promise anything.”11 Investors’ reaction to earnings surprises sometimes surprises even expert analysts.
H&R BLOCK’S $.04 BEAT—THINGS AS USUAL. On June 29, 2009, the tax adviser announced a fourth-quarter EPS of $2.09, beating the consensus by $.04. Revenue, at $2.47 billion, however, fell a little short of analysts’ expectation ($2.52 billion). Investors nevertheless reacted to the bright side. H&R Block’s stock price advanced 11.7 percent on the announcement (the S&P 500 was virtually unchanged). The takeaway is that anything is relative; in the depressed market from 2008 to 2009, any positive news looms large.
These seven cases of consensus hits and misses with their consequences clearly indicate that there is much more to investors’ reactions than a mechanical response to the earnings surprise. Context is crucial, in particular, the stock price pattern prior to the earnings release, to which I turn next.
Riding a Tiger
Why are some earnings disappointments punished severely, while others escape unscathed? The long answer is that there are many reasons. A sales, cash flow, or gross margin disappointment jointly disclosed with the earnings miss obviously paints a particularly bleak picture of things to come. So is an earnings miss coupled with a downcast management outlook of the future. But there is an equally important, although less appreciated, determinant of the reaction to an earnings miss and, importantly, one that managers can proactively alleviate: investors’ pre-miss growth expectations.
In a comprehensive study of the consequences of missing, meeting, or beating consensus quarterly estimates, published in 2002, accounting researchers Doug Skinner and Richard Sloan documented that the stocks of companies that missed the consensus dropped by 5 percent, on average, whereas those that beat the consensus increased 5.5 percent (prices of companies that exactly met the forecast rose by 1.6 percent), over the three months ending with the earnings release (thereby reflecting investors’ aggregate reaction to managers’ guidance and analysts’ forecast revisions made prior to the final earnings announcement).12 The important insight of Skinner and Sloan came from ranking the disappointing companies by investors’ growth expectations prior to the earnings release, as measured by the market-to-book ratio (the ratio of the forward-looking stock price to the historical-based book or equity value per share). Whereas the disappointers with low prior growth expectations saw their stock prices decrease by 3.6 percent, the earnings disappointers with high prior growth expectations experienced a double price whammy: a 7.3 percent drop.13
Even more surprising, the price hit to an earnings miss is only slightly affected by the magnitude of the disappointment, and even small shortfalls of a penny or two by erstwhile highfliers result in sharp price declines, as in eBay and Google. Moreover, whereas for all stocks, investor reaction to positive and negative surprises is roughly symmetrical, for high-growth stocks, the negative reaction to an earnings disappointment is substantially more severe than the reward for a similar positive surprise. Paraphrasing Willing Congreve in The Mourning Bride, hell hath no fury like a shareholder scorned. The price hit to disappointing highfliers is accentuated by “momentum investors,” that breed of market players riding the growth tiger, who are quick to bail out on the first sign of the end of growth—often an earnings disappointment. This helps explain why the magnitude of the consensus miss matters little. Any miss signals the end of the dream.
There are two important lessons for managers here. The first is reflected in the familiar adage, there is no free lunch. Investors’ growth expectations and the consequent elevated stock price have their obvious benefits—lower cost of capital, high managerial stock-based compensation, employment attraction—while the favorable situation lasts, but the retribution for even minor faltering of the growth is commensurately high. Second, the research I discuss in the next section indicates that investors and financial analysts tend to be overly optimistic about the growth prospects of companies with good track records, believing that the fast-growing sales and earnings will persist far into the future. The steep stock price decline upon a consensus miss is, therefore, not just a reaction to the disappointing earnings, but primarily a correction of the overly optimistic growth expectations. The message to managers is that if you suspect that your company’s stock is overheated, outstripping the business fundamentals, resist the temptation to ride the tiger—go along with the market—and instead gradually cool off investors’ enthusiasm to avoid their wrath when the inevitable end-of-growth materializes. In chapter 5 I provide diagnostics on how to identify overheated stocks and prescribe safe means of dismounting the tiger.
A Brief but Important Detour on Value Versus Glamour Stocks
The sharp investor reaction to an earnings miss of the erstwhile growth company I discussed earlier is related to a major puzzle in capital markets: the consistent, yet counterintuitive superior performance of “value stocks” relative to their “glamour” (growth) counterparts. Drawing attention to the different performance of value and glamour stocks is often attributed to Benjamin Graham, a successful money manager and Columbia University finance professor from 1928 to 1957, whose reputation has resurfaced in recent years by the claim that the legendary investor Warren Buffett developed his finance acumen in Graham’s class. Graham defined value and glamour by relating stock prices to various financial indicators, such as earnings, book value, or cash flows. Glamour stocks have relatively high valuations—high market-to-book (M/B) or price-to-earnings (P/E) ratios—while value stocks are characterized by low valuations.14
It isn’t surprising, of course, that investors favor certain stocks, while others are in the doghouse. If investors expect company A to grow faster than B, they will bid up the shares of the former, resulting in a higher valuation ratio (P/E or M/B) for A than B. However, and this is the basic tenet of efficient (rational) capital markets—one of the fundamental concepts of modern finance theory—if investors properly price securities, taking into account all available information about growth and