With the fiscal year entering the halfway point, the spotlight turns to earnings season – a sort of quarterly report card that tells the world whether a company meets, beats or misses the analyst consensus.
Markets hang on the results. Any deviation from expectations can jolt a stock price. The broader markets also may be affected, at least for the short term.
But earnings surprises are not really that surprising. Last quarter more than 68 per cent of the companies listed on the S&P 500 posted earnings that exceeded expectations. On average 63 per cent of companies in the S&P 500 have beat expectations since 1994.
Regardless, beating expectations can generate headlines for the company and enthusiasm for its stock. That's why critics pass off earnings season as an exercise in market theatre, where companies manipulate results for a manufactured response.
David Aurelio is a research analyst who collects, compiles and updates earnings for New York-based Thomson Reuters. He says the high beat rate is less about strong earnings and more about lowered expectations.
"As you head into earnings season analysts are typically more optimistic. As they get closer to reporting they suddenly become more pessimistic and lower their estimates," Mr. Aurelio says. Companies often voluntarily lower their expectations ahead of their reporting dates through formal releases to blunt the impact on their stocks, he says.
There is no conclusive proof that missing or beating estimates has a long term impact on a stock price or the broader markets, but there's no denying it can send a stock on a wild ride over the short term. A recent study by Thomson Reuters found S&P 1500-listed companies that beat earnings estimates outperformed the broader index by 1.6 per cent the following day.
"The bigger factor in terms of price movement is the surprise – how much a company beat or missed by," he says.
Inversely, the companies that missed their earnings estimates underperformed the index by 3.4 per cent the next day. "You see more of a correlation to the missing side. When they're beating, there could already have been the expectation that they are going to beat. It's a bigger surprise if they miss." Mr. Aurelio says surprises on revenue and guidance for future quarters can also have a big influence on stock movement.
Finance industry veteran Norman Levine has a more cynical view of earnings season.
"Are they manipulated? Sometimes," he says, citing instances of creative accounting from companies that want to project the image of underpromising and overdelivering. "Sometimes you borrow from the next quarter."
Mr. Levine, who manages investments for Toronto-based Portfolio Management Corporation, even puts the analyst ratings under suspicion, saying analysts will often adjust them to curry favour with the companies they cover.
"There's always a positive bias on analyst ratings. The analysts want access to the company and companies can be very fickle. If somebody is negative on their stock, they may not want to talk to them or give them the same access as someone who is positive."
The relationship between investment banks and their research departments is at the root of the deception, he says. That relationship came under scrutiny following the technology meltdown of 2000, when firms were giving suspiciously positive ratings to stocks in companies they owned or held as clients. As a result, regulators imposed what are called "firewalls" between research and investment operations.
Mr. Levine says the practice is less overt today, but the pressure on researchers to cast clients or potential clients in a good light still exists. "If you have a negative opinion on a stock, investment banking looks down on you very badly because it makes their job of getting new underwritings from companies much more difficult."
That pressure is reflected in their often-quoted "buy, sell, hold" ratings, he says. "Some brokerage firms have a strict policy requiring a certain percentage of buys, a certain percentage of holds and a certain percentage of sells. The certain percentage of sells is always a lot less."
And then there are target prices, often included with the analyst rating. A buy recommendation normally means the analyst feels the stock is undervalued and will soon rise to the target price when the markets realize its fair value. Investors can take them as a signal to keep buying as long as the current market price is below the target price.
"Target prices are meaningless," says Mr. Levine, who feels their real motive is to generate more trades and more fees for the industry. "Analysts move them during the quarter and during the year. They are really there for retail brokers to use to generate commissions."
Analysts will usually raise the target once the stock hits the original target price. He says a hidden negative sentiment can be revealed if that doesn't happen. "When it hits a target price and the analyst downgrades the stock, pay a little more attention."
His advice to investors is to learn from the market swings that come during earnings season and snap up good, discounted stocks that are down on an earnings miss.
"Earnings season just brings more volatility to the market," Mr. Levine says, "and it can bring opportunity for investors."