Day: September 12, 2014

In my opinion, Scott Adams is one of the great satirists of the 21st century. He frequently uses Dilbert to poke fun at companies, management, and the work force. In this strip, Scott is pointing out that the investment analysts that publish earnings expectations either don’t know what they are doing or are being “managed” by the company executive management.

Unfortunately, I cannot reprint the Dilbert cartoon here due to copyright issues. I can reproduce the text of the conversation as fair use though. If you would like to see the cartoon (which is much more humorous), please click here.

The C.E.O.: You should be proud that we beat earning that analysts expected.

Dilbert: Why should we be proud that analysts are bad at making estimates?

The C.E.O.: Those bad estimates don’t happen on their own. I had to mislead them.

Asok: I’m proud of you.

Analysts following a company have an official annual and quarterly earnings estimate for the company that they make public. They construct these expectations based on many different points of data, including company conference calls, previous earnings reports, market trends, sector strength, etc.

The problem is that many companies tend to “manage” their earnings expectations. Meaning, they will purposely project conservative earnings expectations so that they can beat those expectations on a quarterly and annual basis. No one wants to invest in a company that is missing earnings expectations, no matter how robust those earnings. So companies will manage expectations in order to “beat” earnings each quarter. Being able to tell mutual fund and hedge fund managers that we have “beat quarterly expectations 14 quarters in a row” is quite a powerful market tool for bringing new investors to the company.

This problem was actually much more prevalent a decade ago. Some companies managed their earnings expectations by doing things that were at best unethical and at worst illegal. Now many of those unethical techniques are illegal.

Most analysts are incredibly smart and very honest. They are trying very hard to predict the expected earnings of the company they are monitoring. However, they are not without error. Also, it is inherently a conflict of interest that managers want the earnings expectations to be slightly lower than actual results. Not so low that it embarrasses the analyst, but low enough that the company looks like it “beat” those expectations.

The real challenge is trying to figure out what a small investor should do about beating or missing expectations. Best advice: don’t worry about it. You only need to worry about where the masses of investors are going to take the stock. As a momentum investor, you simply need to see if the market is happy or unhappy about the quarterly or annual announcements. Trying to interpret the result of beating or missing expecatations is a very short-term game that will probably make you wrong as often as you are correct.

Photo by Ol.v!er [H2vPk]