Keep Watching the Guides
Signs of unsustainable benefits are often revealed in guidance trends
In the movie Casino, Robert DeNiro explains the world of checks and balances designed to keep people honest:
“In Vegas, everybody's gotta watch everybody else. Since the players are looking to beat the casino, the dealers are watching the players. The box men are watching the dealers. The floor men are watching the box men. The pit bosses are watching the floor men. The shift bosses are watching the pit bosses. The casino manager is watching the shift bosses. I'm watching the casino manager. And the eye-in-the-sky is watching us all.”
One of the risks when it comes to company earnings these days is the checks and balances have all but vanished. A company will give detailed guidance for the future quarter or year. Normally, that includes a prediction for revenue going forward along with information about costs and margins to come up with their EPS targets. Security analysts will ask questions about confidence level, timing, specific products and all that guidance and explanation becomes the EPS figure the market expects the company to report in the future. That process is well laid out just like in Casino.
The problem comes when earnings are announced. That earnings target was entered into every stock trading computer and then the newswire feed for earnings is matched against that target instantaneously every morning. If the earnings exceed the target, program trading bids the stock up, and news articles are automatically written that Company X beat its $1.20 forecast by 5 cents before most people have even opened the PDF of the press release. What happened to all the checking and ensuring that results were achieved via quality means vs. a one-time surprise?
In many cases, just checking some of the assumptions from last quarter’s guidance against the newly reported earnings can quickly illustrate whether an earnings beat was a quality beat that can continue or was a one-time gimmick. We will look at a few recent examples of this below.