The first fourth quarter earnings reports are starting to trickle in, although the unofficial start of reporting season isn’t until Monday when Alcoa reports. Of course one component of earnings reports that often moves the markets is guidance for the upcoming quarter and full year. So what happens to stocks when companies release guidance?
It’s far from simple as S&P Capital IQ’s Quantamental Research unit states in their new report entitled “What Does Earnings Guidance Tell Us?” They analyzed the stock performance of Russell 3000 companies after they issued either positive or negative earnings guidance between 2003 and 2015.
It’s important to point out, however, as we move into the fourth quarter reporting season and all the guides we can expect to come out with releases, that the analysts focused on guidance that wasn’t released concurrently with earnings.
Earnings guidance is sometimes more important than results
Look at any number of earnings reports from all across the market, and you’ll notice that management’s guidance has the potential to send shares tumbling or skyrocketing – no matter what the reported quarter’s earnings report looked like. Investors are often more interested in a company’s future rather than its past performance, and it’s easy to see why. Moving into or out of a stock based on guidance can save some serious pain or turn tidy profits because it offers an early look at what the reporting firm’s future looks like.
Analyst Li Ma, the lead author on the S&P Capital IQ report, explains that investors often believe managements’ guidance is purposely set low because they are motivated to beat consensus estimates. In fact, he said almost 70% of earnings guidance numbers are lower than consensus estimates.
For the fourth quarter, S&P Capital IQ’s database shows 64 companies have cut guidance while only 17 have raised it, demonstrating how much more common negative guidance news is compared to positive.
So what are investors to do with these numbers? Past performances of Russell 3000 stocks indicate that it’s important to have a strategy.
Positive earnings guidance drives gains
The S&P Capital IQ team found that, unsurprisingly, positive guidance news causes a company’s stock to increase. Specifically, they describe positive guidance as an outlook that’s either higher than consensus estimates or an upward revised outlook. In fact, they found that the average three-day excess return around the announcement date was 3.07%, which they describe as “statistically significant.” Over the one- and three-month time frames after a positive guidance release, the firm found smaller excess returns of 1.3% and 2.5% respectively.
Conservative annual guidance (an outlook that was lower than the consensus) resulted in a three-day decline of 4.17%. Looking at one and three months, however, the movements were not statistically significant.
For quarterly guidance, the moves were more pronounced:
“Excess returns of companies announcing positive guidance news are significant when the analysis is restricted to return horizons that are not affected by subsequent earnings release,” they added. “Following optimistic annual guidance, the 1-week excess return of companies that reported earnings more than 1 week later was 1.26%.”
The above tables also demonstrate that the earnings releases themselves impact stock prices, particularly when taken into context with the timing of guidance releases for both annual and quarterly outlooks.
“Forward returns with a holding period that overlaps with the subsequent earnings announcements were all positive, and only in one case was it not significant,” the analysts observed. “(1-month excess return for Guidance Up announced between 2 weeks and 1 month before the earnings).”
S&P Capital found that positive guidance news generates positive excess returns during times when there are no earnings releases.
Build a “good news” portfolio
Further, the S&P Capital IQ team learned that portfolios that were created by purchasing companies that released positive guidance over the past month slightly outperformed the market (by 0.69% per month) when adjusting for market, size, value and momentum risk premia. To generate this portfolio, they looked for companies with either an annual or quarterly positive guidance event over the last one, three, six or 12 months and then rebalanced it each month.
“Excess returns were positive and significant at the 1% level for lookback horizons up to 6 months, suggesting that the trading strategy based on positive guidance news generated alpha beyond the compensation to market, size, value and momentum,” the analysts wrote. “The portfolios had a positive exposure to size and value, indicating that the strategy tended to pick smaller firms that were relatively cheap.”
They also observed, however, that analysts may be impacting the stock movements because they often revise their numbers based on guidance.
However, they also found that analyst revisions aren’t entirely causing the stock price movements:
Graphs and charts in this article are courtesy S&P Capital IQ.