Winning (losing) by losing (winning): The power of expectations by Aswath Damodaran
- On September 27, 2012, Research in Motion came out with its earnings report, revealing that revenues dropped 31% and that it lost $235 million in the most recent quarter. Terrible news, right? The company’s stock jumped 18% on the news!!
- A few weeks ago, Apple introduced its newest iPhone, selling more than 5 million iPhone 5s over the first weekend and setting itself on target to beat prior records for smart phones sold. The big story, though, was about a free Map app that Apple was offering with the iPhone, that was misbehaving. The company has lost almost $40 billion in market value in the last two weeks!!
- The audience: In providing guidance to markets, companies have conventionally thought of equity research analysts (especially sell side) as their primary audience. Ultimately, though, it is investor expectations that drive the game, and while analysts may influence those expectations, they are (in my view) more follower than leaders. The companies that are best at moulding expectations talk to investors, though they might use analysts as their messengers.
- The information: For a company to try to guide expectations, it has to have better information than investors do and be able to convey that information to markets. In particular, rather than just suggest that earnings expectations are too high, providing information on specifics such shipments or margins to back up the guidance will increase the impact it has. Companies argue that the Reg FD, the SEC’s rule restricting selectively providing information to analysts, has restricted their capacity to provide meaningful guidance but note that the regulation does not prevent companies from making public disclosures to all investors.
- Credibility: To be credible, companies that try to manage expectations have to be seen as trying to do both manage them down (when they are too high) and up (when they are too low). Too many companies seem to think that managing expectations just implied lowballing earnings and revenue numbers. A study of company guidance statements, the primary device for managing earnings expectations by Factset found that almost 80% of guidance provided by firms in the third quarter of 2012 was negative & designed to lower expectations (rather than raise them). A company that always tries to talk down expectations, while beating expectations each period, is like the boy who cried wolf, more likely to be ignored than listened to.
- Results: The game’s denouement occurs when the actual news (earnings or other) comes out and investors measure it relative to expectations. If investors feel that companies are fudging the number or cooking the books to deliver actual earnings that beat expectations, they will at some point stop reacting to the news.
It is the fact that information disclosures have become a game that has led some companies to choose not to play the game at all, either because they view it as a distraction from their mission of creating long term value for stockholders or because they think it is futile. In fact, my sense is that the payoff to companies from playing this game is become smaller over time and that more companies should consider the option of not playing.
Profiting from the investment game
(1) Sector or company specific knowledge: You could invest resources in learning the inner details of companies in a sector (technology, health care) and use that knowledge to make judgments on which companies will deliver positive surprises and which ones will under perform.
(2) Forensic accounting skills: Accounting statements contain clues about future earnings, and a microscopic examination of current accounting statements may provide clues about the future.
(3) Inside information: I know, I know. It is illegal, at least in the United States, but that does not stop some from trying to use it to get an advantage.
I am too lazy to immerse myself into sector specific information, don’t care much for delving deep into accounting statements and both too risk averse/outside the circle to get or use inside information.
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Even if you don’t want to play the quarter-to-quarter expectations game, you can perhaps turn the game to your advantage in one of two ways. The first is to use it in timing your investments, buying stocks that you think will deliver long term value (and were on your list of “buys” anyway) after they fail to meet expectations. Thus, if you have always wanted to add Apple to your list, you may feel that the Maps debacle is exactly the right time to jump in. The second is to build an investment strategy of buying (selling short) stocks right after “big” expectations failures (successes), on the assumption that investors are likely to be over reacting to the news. That is a strand of contrarian investing, albeit with a shorter time horizon and I posted on this strategy a few month ago.