About two weeks ago, Durham-based Cree suffered a single-day 12 percent loss in its stock price after announcing that its upcoming earnings report is going to fall short of expectations. The company is a leading producer of LEDs for a variety of applications. Even though I don’t own a single share of Cree, my pulse quickened when I saw the announcement and watched the stock sink.
As a portfolio manager, I dreaded the weeks after the end of each calendar quarter. Despite my best efforts to build reliable earnings models, I knew that at least a handful of my portfolio holdings were going to issue disappointing earnings. Months of price appreciation would be wiped out in a matter of hours. What I didn’t and couldn’t know was which companies were going to miss the mark. I still feel the stress when a company’s stock plummets.
This is exactly what happened at Cree. For its first fiscal quarter, which ended at the end of September, Cree had been guiding Wall Street analysts and money managers to expect earnings of 25 to 30 cents per share. Once the books closed, Cree realized that business had slowed in a critical segment and that earnings were going to be lower than expectations. The company issued a press release with the bad news, and the stock plunged. As per usual, several brokerage firms downgraded Cree’s stock from a buy to a hold (Wall Street’s code word for sell), and the stock continued to move downward.
It would take someone far more well-informed than me to determine whether Cree’s current stock price properly reflects the company’s long-term prospects. However, I am quite certain that the company’s recent announcement has little to do with the lasting value of the company. Quarterly earnings and the ensuing stock gyrations have much more to do with Wall Street than they do with investing. Nonetheless, the financial press and investors will spend the next few weeks parsing this quarter’s financial results for lasting meaning until they become fixated on the next quarter’s results in about three months’ time.
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Playing the game
Why are we fixated on quarterly earnings reports? Why do stocks suddenly soar if a company’s profits exceed expectations by a penny or two and plunge if profits are a few pennies short? I’m going to discuss the answers to these questions in the remainder of this column. For starters, let me begin by answering the following question: Is a company suddenly worth 10 percent more or less just because it did slightly better or worse in the last 90 days? Of course not. A company’s value is based on its ability to generate profits over an extended period of time. No one would invest in equities if a substantial part of its value were really determined by near-time financial results. The value of a public company, including Cree, is really determined by its ability to generate sustainable profits over years and decades, not calendar quarters.
The quarterly earnings game matters because a substantial number of market participants are playing it. They may call themselves portfolio managers, but they are really traders, and much of their incentive compensation, and therefore their motivation, is based on short-term results. Their clients, both institutions and retail, spend a great deal of time dissecting short-term investment results. In other words, all too many clients are fixated on whether their portfolio beat or trailed its benchmark in the last 90 days. During my career as an institutional portfolio manager, I spent an inordinate amount of time explaining to clients why a particular stock had missed its quarterly earnings target by a couple of cents per share and plummeted in value. Interestingly, clients weren’t much interested in the handful of securities that had beaten expectations and soared in value. My clients were largely paying me to explain static or noise.
In this short-term environment, the key variable is something called earnings surprise. A good earnings report isn’t one that consists of rising profits. In investing, good isn’t good enough. Instead, those profits had better be better than what Wall Street expected. This is a game that first became widely possible in the late 1970s and early 1980s when computers enabled money managers to compile earnings estimates in a systematic way. The idea was to invest in stocks whose quarterly earnings were likely to beat the consensus and avoid those stocks that were likely to miss.
As a result, portfolio managers spent hours trying to coax CEOs, CFOs, and analysts to reveal meaningful tidbits about the upcoming quarter. All sorts of investment services, databases and models were created to try to tease out stocks that were likely to exceed or fall short of quarterly earnings. Companies responded to this game. Executives tried to manage earnings to meet or slightly exceed Wall Street expectations. A particular sales order might be accelerated or deferred depending on whether the company needed it in order to make next quarter’s earnings. Executives understood, and to some degree the value of their stock options depended on, the earnings surprise game.
As you might imagine, some investors and analysts received preferential treatment from companies receiving useful hints about the upcoming quarter. In 2000, the Securities and Exchange Commission issued Regulation FD (Fair Disclosure) to try to eliminate this special treatment. The SEC wanted to make sure that any change in earnings guidance was widely disseminated and not funneled to favored managers. While the earnings surprise game became more difficult, the quest to unearth earnings surprises continued.
The noise traders
While true long-term investors continue to exist, the stock market is populated with a large number of mutual funds, hedge funds and speculators betting on short-term results. These folks are known as noise traders. They have little interest in the proper value of Cree or any other stock. Instead they are making daily bets. If the bet starts to sour because of a negative earnings surprise, the noise traders will rush to eliminate their positions, leading to sharp price declines. If the bet starts to pay off because of a positive earnings surprise, the noise traders will suddenly and simultaneously add to their positions, and the stock will soar. The behavior reminds me of gamblers who will rush to play a slot machine that is suddenly paying off or avoid a machine that hasn’t paid off in awhile. Although the slot machine’s payoffs are entirely random, gamblers act as if there’s some meaning or pattern in random events. The earnings surprise game creates the same sorts of behavior in the financial markets.
If you are a true long-term investor, you are best served by ignoring the earnings surprise game and the ensuing volatility of stocks that have either exceeded or fallen short of Wall Street’s expectations. However, the advice is much easier to give than to follow. When one of your holdings falls 12 percent in one day, it is very unsettling. In all likelihood, the decline is just noise, albeit loud noise. Under those circumstances, you should be reminding yourself of why you own the stock in the first place. If you have a good answer to that question, you can probably ignore the noise or perhaps even increase your position in the stock. However, if you don’t have a good answer to that question, you probably shouldn’t have bought the stock in the first place because you’ve inadvertently become a noise trader.
Andrew Silton’s Meditations on Money columns can be found twice a month in The N&O’s Work&Money section. He is a retired money manager living in Chapel Hill. He was CIO for the North Carolina Retirement System from 2002-2005. He writes the blog http://meditationonmoneymanagement.blogspot.com/