John Reese is founder and CEO of Validea.com and Validea Capital Management, and portfolio manager for the Omega American & International Consensus funds offered in the Canadian market through National Bank Securities.
Always a highly-anticipated time, earnings season has become even more closely watched in recent quarters, with questions lingering about how consumer spending and corporate profits will shape up in a post-overleveraged world.
Because of that, two of the most widely used words you'll likely hear as the third quarter comes to a close are these: analysts' estimates. As investors try to get their arms around what the economy's so-called "new normal" looks like, the projections that analysts make in the next few weeks about a company's financial performance will be scrutinized.
But while investors will no doubt turn to analysts to try to get an early read on the performance of both individual companies and the broader economy, they shouldn't. Although analysts' estimates are some of the most used and most quoted figures in stock market discussions, they are also some of the most inaccurate.
You can find proof of that in the writings and research of David Dreman, the Winnipeg-born contrarian investor whose approach forms the basis of one of my better-performing Guru Strategy computer models, up 40 per cent this year.
Mr. Dreman believes that the market is driven by how investors react - or more to the point overreact - to "surprises", which include government actions, news about new products, and perhaps most of all, earnings reports that exceed or fall short of expectations. And, according to Mr. Dreman's research, inaccurate analyst forecasts lead to a slew of surprises.
In his book Contrarian Investment Strategies, Mr. Dreman writes of a study performed by A-N Research Corp. and I/B/E/S, which found that between 1973 and 1996 analysts' estimates were on average off by 44.3 per cent - 23.7 per cent too low on positive surprises and a whopping 76.5 per cent too high on negative surprises.
The inaccuracy rates were similar during both recessions and expansions, Mr. Dreman says, and they were high across almost all industry groups. In fact, in only one industry - tobacco - did analysts miss by an average of less than 25 per cent.
Interestingly, Mr. Dreman says that more often that not, analysts err on the high side. One rather startling study that he and Eric Lufkin conducted found that from 1982 to 1997, analysts overestimated the growth of S&P 500 companies by almost three-fold. The average annual growth rate analysts had predicted at the beginning of each year of that period was 21.9 per cent. The actual growth rate? 7.8 per cent.
There are a number of reasons for this over-optimism, Mr. Dreman says. Some are psychological and others are rooted in the way analysts are compensated by their employers. But the bottom line, he says, is this: "There is only a 1 in 130 chance that the analysts' consensus forecast will be within 5 per cent for any four consecutive quarters. …To put this in perspective, your odds are ten times greater of being the big winner of the New York State Lottery than of pinpointing earnings five years ahead."
The More Things Change
Mr. Dreman's book was published in the late 1990s, but it appears little has changed today.
In 2007, for example, analysts had expected S&P 500 earnings to rise nearly 15 per cent, according to Reuters Estimates. Instead operating earnings fell 5.9 per cent, while as-reported earnings dropped 18.8 per cent. And 2008 was a flat-out debacle. A Newsweek article published on the last day of 2007 stated that S&P 500 earnings were expected to spike 15.7 per cent in 2008, according to Reuters Estimates. The reality was different. For the full year, S&P 500 operating earnings declined 40 per cent while as-reported earnings fell 77.5 per cent.
So if analysts have such a poor collective track record of predicting corporate earnings, why should you expect them to hit the nail on the head coming out of this volatile period?
You shouldn't. A more reliable gauge of future growth, I've found, is a firm's past earnings results. My Guru Strategies use a composite of a company's three, four, and five-year earnings per share growth rates results to determine a long-term growth rate, and in doing so are able to strip out anomalous years that may have been impacted by one-time expenses or windfalls. It's by no means a surefire way to predict future earnings - no surefire way exists - but I've found it to be a far better indicator than analysts' estimates.
With that in mind, I thought it would be interesting to look at a few Guru Strategy-approved companies that have been consistently growing their per share earnings over the past five years - and which have been consistently underestimated by analysts over the past four quarters. Regardless of what you hear about these firms from analysts going forward, they have the type of track records and fundamentals that deserve a look.
EMCOR Group Inc. : Based in Connecticut, this construction and facilities services firm does electrical, mechanical, lighting, air conditioning, heating, security, fire protection and power generation systems work for companies in a wide variety of industries. The $1.7-billion (U.S.) market cap firm has surprised analysts on the upside in each of the past four quarters, exceeding expectations by an average of 32.2 per cent. It gets high marks from two of my strategies top-performing strategies, those I base on the writings of hedge fund guru Joel Greenblatt and mutual fund legend Peter Lynch.
Mettler-Toledo International Inc. : Another capital goods firm, Mettler makes a variety of instruments used in research, scientific, and quality control labs in the pharmaceutical, chemical, food and cosmetics industries, as well as tools used to streamline industrial and food management processes. Based in Ohio, the $3.1-billion market cap firm has beaten analysts' estimates in each of the past four quarters by an average of 8.4 per cent, and its strong earnings history is part of why it gets approval from both my Peter Lynch and Warren Buffett-based strategies.
Myriad Genetics, Inc. : Based in Utah, Myriad makes products designed to assess a person's chance of developing a variety of different types of cancers, and to help guide treatment in patients who have developed types of cancer. The $2.9-billion market cap firm has topped analysts' estimates in each of the past four quarters by more than 56 per cent, and its strong growth earns it approval from my Martin Zweig-based model.
At the time of publication, John Reese was long EME and MTD.