Earnings Don’t Miss Estimates

May 08, 2019 | Sam Rook


The proper lens to understand Earnings Season

Earnings didn’t miss estimates, estimates miss earnings.” The first time I read that line was several years ago. Morgan Housel, then of Motley Fool, wrote it as part of this column. I laughed because it was such a silly turn of phrase. Then I got it. My understanding of the narrative around “Earnings Season” changed right then and there. Let me help it change for you.


Each and every publicly traded company has a legal requirement to report their corporate financials to the public in a timely manner. Each quarter of the year, Coca-Cola or Boeing or Royal Bank calculate important things like revenues and expenses and profits. I don’t need to get into the full details but just know it happens and there is great attention paid to it. Because most companies run their business year to coincide with the calendar year, we get a lot of companies reporting their earnings in a 5-6 week period every three months - the aforementioned “Earnings Season” as dubbed by financial media.


Earnings play an important part in any corporation whether public or private. Without earnings there eventually is no more company (sorry, Tesla). A large part of the investment industry is dedicated to predicting these earnings, the idea being that if shareholders invest according to these forecasts, they will profit.  This is why we have financial analysts; they are the investment industry’s version of the weatherperson.


Great attention is paid to the analyst forecasts, but is that the right way to invest? Should you make decisions based on what one specialist in that company thinks is going to happen based on all the information available to them? Most people would say yes, but that doesn’t mean they’re right.


The graph below is the history of Wall Street analyst forecasts for total quarterly earnings per share for the S&P 500. These are the 500 biggest and most followed companies in the US. Each line represents a specific quarter between Q2 2015 and Q1 2018. The leftmost portion of any line is the first forecast published of that quarter’s expected earnings. Each adjustment by an analyst results in a change to the line. The last point of any line is what the actual earnings for that quarter were. You will notice that each line is sloped, almost always downward. For example, the line for 2Q15 (the second quarter of 2015) indicates that the initial forecasts were for S&P 500 earnings to be around $33 per share. They were actually just about $28 per share. 


(Source: Bloomberg and Escala Partners- https://escalapartners.com.au/daily-rung/april-18th-2018)


Why are analyst forecasts typically wrong? Phil Tetlock, noted psychologist, argues they are wrong precisely because they know too much about their specific industry. They are so deep into their specialty that they become driven by confirming their previous thoughts and less interested in conflicting information. This is called confirmation bias. Tetlock’s ground-breaking study on its effects in political science forecasting is summarized in this great piece from The Atlantic.


Tetlock’s work with Barbara Mellers found that a small group of people “curious about everything” had better forecasts than any group of specialists. Even when those specialists had an information advantage by having access to classified information, the generalists beat the specialists. Tetlock and Mellers called the generalists Foxes and the specialists Hedgehogs. Both were susceptible to confirmation bias, but the generalist Foxes were more open to change when an outcome surprised them. The specialists? They barely changed at all.


This is why I stopped paying attention to analyst forecasts. It doesn’t matter what the quarterly earnings are at any given time. Look at that graph above again. Did you notice something else? The actual earnings across all quarters for 2015 were essentially flat. You will also notice that earnings started increasing each quarter in 2016 from $26 per share to $36 in Q1 2018. Can you guess how the S&P 500 index reacted?


Forget estimates and forecasts. You cannot predict the future nor can anyone else. Focus on the things that truly matter to your returns - patience and a good plan.


“It’s difficult to make predictions, especially about the future”- Danish proverb


Sam Rook, Investment Advisor

If you want to get off the quarterly results treadmill and invest in a better way, talk to me today.