Thursday, February 08, 2007

Earnings Season and The Uselessness of Forecasts

We are in the midst of one of the most well-established rituals of Wall Street , earnings season. This is an incredibly intense time for analysts on both sides of the Street, buy-side and sell-side. Conference calls abound, earnings releases flow, and models are quickly reviewed and revamped. Research associates groan under the stress, analysts hit the phones to listen in, or to call out to their Rolodex of clients. A stream of "research" is written, promulgated, and occasionally read. On the buy-side, some analysts and portfolio managers are intently involved in the game of looking for "surprises." The tape is studied to see how the stock is "acting." In other words, how is everyone else thinking.

As a value investor, I find the routine loathsome. The task of following earnings releases is tedious and often quite fruitless because meaningless statistics are forced from such a brief snippet of a company's history. "Proofs" based on a single quarter provide some investors with "irrefutable" evidence of the value of a business. Forecasts and estimates shift, opinions change, and the world transacts.

I checked out how many earnings releases were anticipated for today. Based on "Street Events," a Thomson service, there were 281 conference calls today. A total of 482 earnings releases were also anticipated, without the now-standard conference call. That's a total of 763 securities in which to change your mind. It makes you wonder how much thinking actually takes place outside of earnings season. Is it actually possible to think about a business without looking at the last quarter or listening into a conference call?

A word of revolutionary advice...come to your investment conclusions outside of earnings season. It's a little like not being permitted to do your homework in front of the TV. Too many distractions, too little information, a really rotten time to contemplate what value drivers are really changing in the business that own or want to own. Sound decisions come out of silence.

I found a terrific quote in Value-Stock-Plus, a fellow blogger who in my opinion seems to get "it." He quotes Timothy Vick, the author of Wall Street on Sale who describes the investment problem perfectly:

“Each year, the leading business schools graduate thou­sands of finance students taught the same arcane formulas, the same trading strategies, the same valuation principles, and the same forecasting models. It's no wonder that so few can see the broader context of their actions. No wonder, too, that so few beat the market over time; they futilely spend their days trying to beat each other. These graduates, who are today's market strategists, analysts, and fund managers, have become like Marshall McLuhan's fish that don't know they live in water. They swim in a tank separate from another fully functioning world, yet they believe the people on the outside of the glass need assistance. They, however, are the ones trapped."
A very complete article on the uselessness of forecasts, written by Chetan Parikh is also highly recommended. As he puts it,

"In short, Wall Street exists to sell you something. All the financial information it issues, whether brokerage recommendations, price targets, market forecasts, earnings estimates, or performance figures, can be twisted to serve the purposes of whoever issues it. Wall Street generates reams of statistics for investors to digest, little of which has any relevance to your specific situation. In general, investors should be skeptical of almost all data offered them and never buy a stock based on future esti­mates other than those they themselves make."

The future is always difficult to divine. Successful value investors always start with something as close to terra firma as they can. Like Bruce Greenwald suggests in his book, start with the most reliable information first...what is the asset value now...what are the assets themselves worth. The second most reliable information is based on current earnings, or at least current earnings power. There is a substantial difference. But appreciating a business that has long lasting earnings power is the only reason why one would pay more than current asset value for a business. The last and most difficult step in valuation is the third step, forecasting that earnings power into the future with a growth rate.

Unlike CNBC commentators who relish dumping on analysts, I respect them highly. Much of the street needs instant analysis. It is required of them, but not of you! If you think about it, there are 91 days in a quarter. The time to think about your investment need not be relegated to just one day in that quarter. The remaining 99% of the quarter is a much better time to think about it.

One final quote: "When investing is buoyed by short-term earnings-which in turn, swims on the current of predictions-it ceases to be investing, and becomes gambling."


At 11:23 PM, Blogger Deborah said...

Awesome post.

I never went to business school and some of the things that I see that people use to determine valuation, well, it seems to put people at perilous risk for losing their investment.

I worked in a bank for 5 years and I look at it much more the way a bank would about lending you money. What are the assets and what is the ability to pay it back.


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