Companies “guide” earnings – should you listen?!

One more earnings season closes with TV channels getting analysts and other talking heads to discuss earnings “hits and misses”. Companies that have delivered results better than “expectations” are immediately rewarded by higher share prices e.g SBI, while those that have disappointed are sold by investors e.g Infosys. Setting expectations – and then beating them - seems to have become essential strategy for a CFO/CEO seeking to maximise near-term shareholder value. What role does “management guidance” play and should companies seek to set investor expectations through frequent earnings guidance?

Forward looking statements and earning guidance

Forward looking statements are meant to help the investor community, especially analysts, take a considered view on the earnings outlook of a company. Earnings guidance is more specific – it usually relates to making a forecast of the EPS (earning per share) of the company.

The case for management making earnings forecasts is to lower information asymmetry – where a more informed investor is able to make better investment decisions as opposed to the lay investor. It is supposed to help lower stock price volatility because investors are more informed of the management’s view and can presumably invest with greater confidence – or so the theory goes.

The counter- argument is equally powerful. Paradoxically, frequent management guidance makes the investor community heavily dependent on management input. Variations in performance from stated targets leads to violent market reactions – making the stock price more, not less, volatile.

When combined with a company that tries to “game” the investor, by first guiding for a lower performance, and then delivering better, it leads to generation of “whisper number”. Much like a dog chasing its tail, it then becomes difficult to predict if the performance measure that the market is using as “benchmark” is the official (lower) forecast or the higher “whisper number”. In either case, the credibility of management guidance is suspect.   

Management Myopia

A research conducted in 2007 by Mei Cheng et al explains the problem through this interesting diagram below. Their conclusions are even more interesting – “dedicated guiders invest less in R&D, meet or beat analyst consensus forecasts more frequently and have significantly lower long-term RoA growth than occasional guiders.” They term this “myopic” managerial behaviour – sacrificing long term growth for the purpose of meeting short-term ones.

Endogenous nature of earnings guidance

 

Does management have predictive capability?

Another issue with guidance is the limited ability of management to be accurate. In my experience, I have seen three scenarios where management guidance is reliable:

The first scenario is where the industry outlook is so good that even mediocre companies are able to deliver high growth. The IT industry in the mid nineties is a case in point. Here, companies manage to beat guidance regularly, and, usually have a “buffer” of earnings which is carried forward to the next quarter. Predictable earnings growth quarter on quarter in a high-growth backdrop makes for very “prescient” managements. The crystal ball becomes a lot murkier when the industry becomes more competitive. In my view, Infosys currently suffers from this malaise.

The next scenario is when the company operates in a sector where product changes are slow, and consumer behaviour is the dominant variable. Fast moving consumer goods is a suitable example. Consumer behaviour for low involvement products changes slowly, and this reduces performance variability. As with all generalizations, this too is prone to challenge – the story of Hind Unilever vs Colgate, or Nirma vs HUL is too well known. But the exceptions prove the rule – when the road is straight, the rear view mirror can be used to drive the car – bar the accidents! And managements are great at looking at the rear-view.

The last scenario is when we deal with banks and financial institutions. Looking at the annual report of a bank always reminds me of a painting of Pablo Picasso! It’s what you imagine it to be. No other industry allows such creative accounting –the management’s ability to predict earnings 5 years out to the second decimal is a given!

In most cases, the ability of management or forecasters to spot a change of trend before it happens is almost non-existent. Crompton Greaves was projecting great exports to European countries well after the collapse of demand in these areas. In Apr 2011, World Steel Association (WSA) was predicting steel consumption in India to grow 13.3%. By Oct 2011, the estimate was lowered to 4.3%. WSA members produce 85% of the world steel output. The list is endless. In the current environment of extreme macro-economic volatility, this predictive capability is even lower.

Interpret guidance- use the data, ditch the prediction

The best use of a management commentary is to take note of the details. In between results, only the management can tell investors how the business is faring. Details on deals done, those underway, and the performance till the day can be informative to the investor. However, when it comes to making forecast, a dose of healthy scepticism coupled with an overarching macro viewpoint will be a more reliable aid.

Investors tend to believe that managements have some special insights on the business. While this may be true about technology, competition, and market dynamics – it rarely extends to a greater predictive capability. When it comes to the future, trust your own judgement. It has as much a chance of being correct as that of the management.

Forecasting Market Direction II

Second part of my column on forecasting market direction. The article is reproduced below.

The author takes a macro look at liquidity & interest rates, two key market direction components

By Anand Tandon | May 26, 2012

In my previous column, I had discussed growth and valuation as two components of my four factor model for determining market direction over the medium term. In this column, I discuss the other two macro components – liquidity and interest rates, and how to tie up all the factors to estimate market direction.

Liquidity

Liquidity can be interpreted in various ways. In simple terms it determines the extent of mismatch between demand and supply of money. Since monetary authorities often attempt to “manage” liquidity through market operations, a market driven measure is difficult to find. We often have to do with proxies.

At a macro level, liquidity can be measured through money supply (called M3 by economists). As the graphs demonstrate, M3 as a forecaster of market direction worked well for most of the decade of 2000. Post 2008, the correlation between market direction and M3 apparently broke down – central bank interference has, since, become the norm.

Other measures of liquidity can be FII flows, the liquidity adjustment facility of the RBI or measures such as TED spread (price difference between three month futures on US treasuries, and the identical contract in Euro).

At the level of the market, liquidity is easier to measure. Volatility can be taken as a proxy – lower the volatility, higher the liquidity. Other measures include impact cost of trades (difference between the buying and selling price) or intra-day high-low of stock prices.

Whatever the measure, the impact is likely to be the same. Easing of liquidity conditions helps in taking the market up. The reverse is true when money becomes tight.

An interesting outcome of this is the impact on “mid-cap” or less-traded companies. Smaller companies usually trade at a valuation discount to the larger, well-traded companies. This often leads “value investors” to invest in these companies. While this may be a valid strategy for someone having an investment horizon exceeding 5 years, it can be painful for investors (or fund managers) who look for near term performance.

When liquidity dries up, the smaller companies are the first to feel the impact of tight liquidity and fall in stock prices of such companies is usually steeper than their larger (more liquid) counterparts. In other words, invest in mid-cap value only when liquidity conditions are benign, and are likely to remain so. Value investing can easily become a value trap for the unwary.

Interest rates

Interest rates are fundamental to valuing any asset – financial or real. At the heart of investing is the desire to earn a return that preserves or grows the value of money. Interest is the benchmark for measuring the effectiveness of any investment. Since the concept of interest is relatively simple, I will not attempt to explain it. However, I have often observed that most people do not realize that value of all investments fall when interest rates rise – equity, debt or real estate. A simple way to understand this is to see all assets as generators of cash flow – dividend, coupon rates or rent. We use present value of these cash-flows to measure the value of each investment and that uses interest in the denominator. In other words, unless the cash flow from investment increases when interest rates rise (for example, in the case of inflation adjusted bonds), asset prices will fall when rates rise.





Another point worth mentioning is that liquidity and interest rates do not need to move in the same direction, though they may. It is therefore necessary to examine each separately.

In the market, all interest rates are not equal. I had earlier referred to a study by the RBI where it postulated that inflation rate below 6 per cent may help growth while above it, it is likely to harm. Likewise, when interest rates rise above 7-8 per cent (from lower rates) impact on markets is more adverse. Increase in rate from say 4 to 5 per cent is less likely to impact. This is explained by the assumption that at lower levels, the differential interest rates can be passed on to consumers – without impacting corporate margins and therefore protecting (enhancing in nominal terms) the cash flow. However, higher rates meet consumer resistance forcing companies to absorb the rate increases with consequent lower margins. Likewise, on the way down, a drop from 8 to 7 per cent is more likely to have a positive impact than one from 10 to 9 per cent.

The last question to consider is what interest rate we are referring to. For the purpose of the stock market, we should look at the borrowing cost of companies. Since this varies from bank to bank and company to company, it is normal to consider the base rate of banks. Even simpler is to track the repo rate: the rate at which banks borrow from the reserve bank.

Putting it together

In the very short term, liquidity overwhelmingly determines the direction of the market – higher liquidity leads to higher market levels and vice versa. However, over the medium term, say 3 to 6 months, the dominant factor is the earnings and its growth. Higher growth will support higher levels. In a benign interest rate scenario, or one where interest rates are expected to fall, valuations will rise.

In all this, change in levels is more important than the level of each variable. However, when variables cross thresholds (for example, interest rates go beyond 8 per cent, or earnings rate falls below 15 per cent) the impact is greater.

In the current context, as we mentioned earlier, earnings growth is expected at 12 per cent (anaemic but better than last year: positive), interest rates may fall further (they are at the threshold of 8 per cent: a further cut can have a large upward impact on markets: positive). Liquidity is poor (M3 is falling: short term negative), but valuations (at around 13-14x: positive) are at the lower end of the 12x to 18x band. Downside in the market can therefore come from liquidity shocks. Otherwise, potential upside to downside risk is in favour of the equity investor. Buying dips may work well for the patient investor.

Forecasting Market Direction - A Macro Perspective

A two part column which I had written for Wealth Insight for March and April. Can't locate this in their website, so I am posting from my own copy.

Investors constantly seek an answer to the question – “which way is the market headed”? Answers usually take the form of unsupported opinion –“ I think it will go up/Down”. Sometimes, it involves some arcane justification – “India is a growth market and will therefore go up”. The quantum of solace the first response provides is dependent on the profile and reputation of the speaker. It is totally unhelpful to the questioner in making decisions in the future. The second response is even more useless in terms of its information content. India was always a growth market (in terms of GDP) , but equity markets have remained in a range over 16 years of the past 20.

A systematic investment plan helps to remove the requirement of market timing. However, it requires investors to take a really long term view of investing and have the patience to sit through long periods of no gain.

A macro approach to market timing

Markets respond to many factors simultaneously. Often, investors are not able to identify the primary driver of market movement, and when to use what indicator. I present a simplified formulation to help decide the market direction over the near term (say the next 6 months) on a broad brush basis. A word of caution - when we use macro numbers that change slowly – sometimes once in a quarter or so, the indicators are not in a position to forecast daily or even weekly moves. At best, they provide a framework within which near term movements can be viewed or interpreted.

My simple framework has four components – growth and the price of growth, money and the price of money. Let us look at these in some detail.

Growth

This indicator is among the most common indicators in vogue. A growing company will, over time, generate more wealth as compared to one which is not growing or growing slowly. The underlying assumption is that there is some “equivalence” in the capital employed, and the risk of the operating business. A company may generate a higher profit or cash flow if it has more capital than its peer. That does not count. Similarly, a business that is more risky will need to generate a higher return to attract investors. In all this, we speak of growth in profits. There are several subtleties here – a growing company which is rapidly adding customers will, perhaps in the near term, lose money (for example the early stage development of telecom companies), but may be an attractive investment. This is because investors assume that when the rate of client addition slows, profits will shine through. There are other issues, but I want to skip these and keep it simple.

How do we estimate growth? and especially for the market as a whole? The way we get this is by taking the consensus of the estimates made by analysts tracking the companies in an index, say, the sensex, and then combining it in the same proportion as the company’s weight in the sensex.

For example, current estimates for sensex earnings are :

Table 1	FY12E	FY13E
EPS (sensex)	1163	1303
Growth	5.4%	12%
P/E (@ sensex of 17360)	14.9	13.3

The “price” of growth

The price of growth is commonly called “valuation”. Since investors prefer a company that is growing faster to one that is not, there will be a tendency to pay more for growth companies. In other words, the growth is often “in the price”. We therefore need to compare the “valuation” ie, how much are we paying to own a share of the company for each rupee of profit that the company earns. The ideal way to compute this would be a “discounted cash flow model”. However, a rule of thumb that works reasonably is P/E. A company with a high E/P (earnings yield) is generating profits that are priced more reasonably, as compared to one with a lower earning yield.   As always, there are several issues here. P/E does not take into account the capital employed to generate the returns. Take the case of two companies below:

Table 2	Company A	Company B
Sales	1000	1000
Profit from Business	100	100
Shareholders fund used	100	200
Equity Capital	100	100
Reserves	0	100
Earning per share (EPS)	Rs 1	Rs 1
Price per share	Rs25	Rs 25
P/E	25	25

On the basis of EPS and P/E, it appears that the two companies are identical. Clearly they are not – “B” uses twice the amount of shareholders capital as compared to “A”. Of course, this will be reflected in the share prices of the two companies (they won’t be equal as assumed above). The point to be remembered is that Return on Equity (RoE) is far more important that P/E in looking at investments. But, we use P/E as a proxy since it is easier to compute and understand.

 

How do we use P/E? First we must have a benchmark. The graph shows the rolling P/E of the sensex over the past 25 years. When smoothed over 5 and 10 year periods, it is clear that the valuation of the market rarely stays at or below 12x, generally trades at 14x-16x and except when in a raging bull market (1992, and 2000) rarely goes beyond the range indicated.

It appears that with the current estimates for consensus earnings (Table 1), we are trading at 14.9x march ending 2012 earning, and 13.3x next year earnings. In the context of the earlier graph, the market is “cheap”

I will discuss the other two factors in my next column, and then propose a simple method to use them as a general guide on when the allocation to equity assets can be increased. On the data discussed so far, it appears that while earnings growth will increase (the previous year EPS was 1103 – which implies a 5.4% growth from FY11 to FY12e), valuations are relatively cheap – should you be increasing your equity asset allocation? Perhaps, but we will find out.