Everything the mainstream says about earnings is wrong

Overview

It’s “an article of faith among Wall Street research departments,” wrote David Dreman in Contrarian Investment Strategy (1979): “Nothing is as important in the practice of security analysis as estimating the earnings outlook.” Whether for individual companies or a market Index, “forecasting (earnings) is the heart of most security analysis as it is practised today.” More than 40 years later, in Australia as well as the U.S. and elsewhere, Dreman’s assessment remains apt. As a result, conventional security analysis has long lacked sound logical and empirical foundations.

Its fatal flaw is two-fold. First, the strength and direction of the influence of earnings upon returns are so erratic that, in the short term, it averages zero. In Do earnings drive stocks’ returns? (22 January 2024) I demonstrated this crucial point with American data; in this article, I corroborate it with Australian data.

The implications are enormous. A pillar of the mainstream’s obsession about “consensus forward earnings” – namely that markets boost the shares of companies whose earnings “beat the consensus estimate” – is generally false. Similarly, investors don’t consistently punish companies whose earnings “miss” expectations. Moreover, companies which provide earnings guidance aren’t valued more highly than those which don’t; nor does their “forward guidance” tamp the volatility of their shares’ prices.

Mainstream security analysis suffers from a second fatal flaw: human beings – including me, you and “expert” analysts – are innately poor forecasters. Everybody occasionally gets lucky, but nobody can reliably foresee companies’ earnings, stocks’ prices, markets’ levels, etc. In particular, nobody can consistently predict these variables’ turning points.

In Contrarian Investment Strategies (2011), Dreman finds that analysts’ ability to foretell earnings reliably is so poor that it’s “impossible to distinguish growth stocks ... from average companies ... or even from also-rans.” He therefore asks: if earnings estimates “are not (accurate) enough to weed out the also-rans from the real growth stocks, ... why (would) anyone pay enormous (earnings) premiums” for alleged growth stocks? His conclusion more than 40 years ago remains sensible: the experts’ consensus of expected earnings “should be viewed with some suspicion.”

My analysis concludes that, for the sake of their financial health, investors should ignore companies’ earnings guidance, analysts’ consensus of forward earnings – and the journalists who parrot them.

I also demonstrate that those who obsess about forward earnings don’t merely err almost continuously and sometimes enormously: they also blunder systematically. The consensus of forward earnings’ level and trend is unable to foresee corrections (and bigger events such as the Crash of 1987, GFC, etc.); but the sudden realisation that expectations have enormously outpaced reality – as it now seems they’re doing – can trigger them. Yet as I’ll also show, if you know where to look, are prepared to think for yourself – and when necessary to defy the crowd – you can act pre-emptively.

Leithner & Company’s awareness of analysts’ tendency to "systematically mispredict" earnings – and our crucial insight that essentially everything the mainstream asserts about earnings is demonstrably false – has on several occasions enabled us to anticipate and take advantage of downturns. Today might be one of those occasions.

Unfortunately, those who heed the consensus have – like the supposed experts who comprise it – repeatedly been caught unawares; accordingly, they’ve often endured – and will likely continue to suffer – significant losses.

Actual (“Trailing”) versus prospective (“Forward”) earnings

It’s vital to distinguish a company’s or index’s actual (“trailing”) earnings for a past period from its prospective (“forward”) earnings for a future period. Trailing earnings during a given month are (1) actual earnings during the previous 12 months. As such, they’re (2) consistently and (3) strictly defined. In short, they conform to Generally Accepted Accounting Principles. Colloquially, GAAP earnings include “all the bad stuff.”

In practice, actual earnings are of secondary – and usually of little – interest to analysts. Instead, “forward” earnings preoccupy them. “Consensus forward earnings” during a given month is the mean of analysts’ estimates of a company’s or market index’s earnings during the next 12 months.

Importantly, this consensus doesn’t attempt to foresee GAAP earnings: forward estimates routinely incorporate “good stuff” (such as one-off gains) and exclude “bad stuff” (such as allegedly temporary losses, write-downs and write-offs of assets, etc.).

Forward estimates, in short, are inconsistent over time; they’re also transient (that is, the estimate for a particular point in time is revised repeatedly as time passes) and subjective at all times. What’s their rationale? According to Investopedia, “forward earnings are of interest … because stock prices (and market indexes’ levels) are supposed to reflect future earnings prospects discounted to the present … The (economy’s) position in the business cycle, and the state of the economy … can help determine forward earnings numbers.”

A brief digression – Which consensus estimate counts?

During the late 1990s, the U.S. Congress enacted legislation that protected companies from liability for statements about their projected performance. To greater or lesser extents, during the next decade, other countries did likewise. As a result, since then CEOs have commonly issued earnings guidance – and analysts have ubiquitously estimated forward earnings. Analysts and CEOs disgorge estimates and guidance because they believe – fervently – that these predictions systematically affect shares’ prices.

What does it mean to beat, hit or miss the consensus estimate of earnings? The uninitiated might think that it’s a straightforward matter, but it isn’t; Koller et al. (“Avoiding the Consensus-Earnings Trap,” mckinseyquarterly.com, January 2013) clarify it.

Suppose that on 15 February 2023 X Ltd reported its actual (trailing) earnings of $2.00 per share for the year ended 31 December 2022. Also on 15 February 2023, the consensus– that is, the average of the brokers covering the stock – forward estimate of earnings for the year to 31 December 2023 was $2.10. By 15 February of this year – well after the conclusion of the period in question, taking into consideration X’s half-year results but before the release of its full-year earnings – the consensus forward estimate for 31 December 2023 had fallen to $1.98. And on 15 February 2024 X reports actual earnings of $2.00 per share for the year ended 31 December 2023.

Did X Ltd’s actual earnings for CY23 exceed the consensus forward estimate? It’s vital to understand that analysts constantly revise their estimates of forward earnings for a given interval; and according to conventional practice, a company (or market) has beaten the consensus estimate if its actual earnings are greater than the final consensus estimate – which almost always appears AFTER the period in question has ended!

Accordingly, in this example X has beaten the consensus estimate of forward earnings, which fell 5.7% during the year, even though its trailing earnings were 4.8% less than the consensus estimate at the beginning of the year!

Do short-term earnings changes consistently drive short-term returns?

Why do analysts, CEOs, investors and journalists obsess about forward earnings? They believe that companies must at least meet (and preferably beat) beat the consensus forward earnings estimate. They hope that if a company consistently produces better-than-expected earnings, then investors will boost the price of its shares. Conversely, adherents to the conventional wisdom fear that if the company reports below-consensus earnings then investors will punish its shares – and, by extension, its CEO.

The reality is very much otherwise: over the short-term (rolling 12-month) periods, the influence of earnings upon returns is so erratic that it’s effectively zero (see also Do earnings drive stocks’ returns? 22 January). In practice, this means that if a company reports better than expected earnings then its stock might fall or even plunge. It also means that if it misses estimates its stock might lift or even soar.

“This,” concludes John Csiszar (“How Stock Prices Correlate with Quarterly Earnings and when You Should Buy,” NASDAQ News and Insights, 16 May 2023), “makes basing an investment strategy around an earnings release date a difficult or even risky strategy.”

If, from one month to the next throughout a given interval, earnings and returns changed identically and in the same direction (but not necessary by the same magnitude each month), then the two series would be perfectly positively correlated and their correlation coefficient (r) would attain its maximum value of 1.0. Conversely, if during each month one series increased by some amount and the other fell by an equivalent magnitude, then the two series would be perfectly negatively correlated and the coefficient would reach its minimum of -1.0. Finally, if the monthly change of one series bears no relation to the change in the other, then their correlation is 0.0.

If the relationship between short-term changes of companies’ earnings and returns is general – that is, if it applies to most companies most of the time – then it will appear at the level of the market index over long stretches of time. That’s an easy proposition to test.

Using data compiled by Standard & Poor’s, Figure 1a plots the correlation coefficient (r) of changes of the S&P/ASX 200 Index’s actual (trailing) earnings and returns, for each rolling 12-month interval since January 2006. Using consensus estimates compiled by Bloomberg, Figure 1b plots the corresponding correlations using the S&P/ASX 200 Index’s forward earnings.

Are the Index’s earnings and returns correlated? They usually are – but they’re anything but consistently correlated: sometimes the correlation is strongly positive and at other times it’s weakly so; but as often it’s strongly or weakly negative. As a result, the average coefficient in Figure 1a is -0.01 and in Figure 1b is -0.23 (which, from a mainstream point of view, is the wrong sign).

Figure 1a: Correlations of the S&P/ASX 200 Index’s Actual Earnings and Return, 12-Month Rolling Intervals, January 2008-February 2024

“Variation explained,” i.e., r × r = r², measures the percentage by which our bivariate model reduces (“explains”) total return’s variation compared to a univariate model. On average, then, the change of the Index’s trailing earnings during a 12-month interval explains exactly (-0.01) × (-0.01) = 0.0% of the change of its total return; the change of the Index’s prospective earnings during a 12-month interval explains a mere (-0.23) × (-0.23) = 5.3% of the change of its total return. Other factors – including random fluctuations – explain the other 94.7%.

The most charitable interpretation of these results: on average over more than 15 years, short-term noise has overwhelmed short-term signal. The most reasonable reading is that investors have generally responded randomly rather than consistently or systematically to new information about actual or expected earnings.

Figure 1b: Correlations of the S&P/ASX 200 Index’s Forward Earnings and Actual Return, 12-Month Rolling Intervals, January 2008-February 2024

In the short-term, earnings simply don’t consistently drive stocks’ returns. As Koller et al. conclude: “the promise of meeting or beating consensus estimates and the peril of missing them are profoundly overstated.”

Have recent earnings really been “resilient”?

“There has been a positive start to the year for Australian corporate earnings estimates,” reported The Australian on 2 February of this year. “The aggregate earnings per share estimate for the S&P/ASX 200 has been revised up by 1% in January. Except for utilities and energy, all sectors have seen earnings upgrades ... Almost 68% of ASX 200 companies have seen net upgrades in January.”

“I think what’s happening here is, for the past few years we’ve all been waiting for the earnings cliff,” said the head of Australian equities research at a major global investment institution. “The much-feared earnings cliff hasn’t materialised and certainly at the beginning of 2024 there’ve been very few companies to provide negative updates to the markets.”

The senior executive continued: this “suggests that the past six months (have) been reasonably good across corporate Australia ... (This) is indicative of a stronger earning cycle than most in the market are assuming.”As The Weekend Australian proclaimed on 24-25 February, “a picture of resilience is emerging from Australia’s latest profits reporting season” (see also “Sentiment Upbeat as Earnings Season off to a Great Start,” The Weekend Australian, 17-18 February).

At best, mainstream “analysts” have been as attentive as Mister Magoo; at worst, they’re utterly delusional. The recent course of trailing earnings – which they resolutely ignore – tells a very different story. It flatly repudiates the assertions about “avoiding the earnings cliff;” it also renders upbeat recent assertions about forward earnings highly dubious.

Figure 2a plots the trailing earnings of the S&P/All Ordinaries Index since January 2020; Figure 2b plots these earnings since January 1965. (The All Ords’ trailing earnings are almost identical (r = 0.99) to the S&P/ASX 200’s; for this reason, and in order to maximise the comparability to Figure 2b, in this section I use the All Ords’ earnings).

Figure 2a: Actual Earnings, All Ordinaries Index, Monthly, January 2020-February 2024

After collapsing 75% during the COVID-19 panic, earnings quickly recovered all of their losses and more. On the eve of the pandemic in January 2020, earnings were $355; by April 2021, they’d collapsed to $91; but by February 2022, they’d zoomed to $422.

So-called “experts” appear to be clueless to – or, at a minimum, they’ve refused to plainly confess the fact that – over the past couple of years the trailing earnings of the All Ordinaries Index have sagged almost one-quarter – from $501 in October 2022 to as low as $380 in December 2023 (they bounced slightly, to $391, in February 2024). Is that evidence of resilience?

The course of earnings over the past 60 years also utterly escapes them. The All Ordinaries Index’s trailing earnings have risen from $14.73 in January 1965 to $391 in February of this year; that’s a compound annual growth rate (CAGR) of 5.7%. Adjusted for CPI, they’ve grown from $245 in January 1965 to $391 today; that’s a CAGR of 0.8%.

Figure 2b: Actual Earnings, All Ordinaries Index, Monthly, January 1965-February 2024

For more than 40 years, from the mid-1960s to the eve of the GFC, CPI-adjusted trailing earnings fluctuated without trend and between $200 and $500. They then skyrocketed to their all-time maximum of $722 in October 2008, crashed to $404 in March 2010 and for the next decade fluctuated between $400 and $500. Then came the COVID-19 panic: the Index’s trailing earnings crashed to $104 in April 2021 but then zoomed as high as $530 in October 2022.

Since then, as I’ve already noted, they’ve fallen. On a CPI-adjusted basis, they first reached their present level ($391) in July 2004 – almost 20 years ago! Does that make earnings resilient or stagnant?

Which valuation metric Is best?

“Record highs for Australian shares have investors asking whether it’s time to ride the momentum and buy in anticipation of more gains, or sell and take profits before the market falls,” reportted The Australian Financial Review (“The five models that show shares are still good value at record highs,” 12 February 2024). “The best way to judge whethher shares are cheap or expensive,” it adds, “is to look at common valuation metrics relative to (their) historical averages.”

The price-to-earnings (PE) ratio, it notes, is one of the most common metrics. The higher is the PE, the more expensive is the stock or market, “as you must pay a higher price for the same amount of profits.” And the lower the multiple, the cheaper is the stock or market. The AFR’s article, like the vast majority of analysts, considers the forward PE almost to the exclusion of all others. On 29 February, the S&P/ASX 200 Index’s forward earnings multiple was 16.1, and since 2006 it’s averaged 15.7. “So,” the AFR quoted Shane Oliver, “it would be hard to describe the Australian sharemarket as cheap today on a (forward) PE basis – in fact, on (that) basis it’s slightly expensive.”

That’s not wrong as far as it goes, but it doesn’t go nearly far enough; accordingly, in key respects it’s misleading. Figure 3a plots monthly observations of the Index’s forward PE since January 2006. Several of its anomalies (I’m tempted to say “absurdities”) highlight the weakness (I’m tempted to say “fatal flaws”) of the forward PE as a measure of value.

Most notably, if before the GFC you had relied upon the consensus and its forward PE ratio, then the Crisis would have caught you – as it did the “experts” – completely unawares.

Figure 3a: Forward PE Ratio, S&P/ASX 200 Index, Monthly, January 2006-February 2024

Between July 2007 and November 2008, the forward PE fell from 16.1 to 9.3. In the latter month and by this measure, the market didn’t merely become considerably cheaper: it was less expensive – and thus more appealing – than it’s been at any time since 2006. If in July 2007 you heeded this strong “buy” signal, then by November 2008 you would’ve lost 39%.

Conversely, between May 2020 and January 2021 the forward PE was very expensive (more than 20 and as high as 26.7). During this interval the Index averaged 6,121. If you had sold during these months and waited to buy until April 2022 (by which time the forward PE had fallen to a much more appealing (15.0, a bit below its long-term average) you would’ve missed the market’s rise of 29%.

What if you had ignored the forward PE and instead taken into consideration the trailing PE and cyclically-adjusted PE (CAPE)? Figure 3b plots these ratios, as well as the forward PE (the trailing ratio rose above 80 during the COVID-19 panic; in order to maximise Figure 3b’s readability, I’ve scaled its y-axis to a maximum of 30).

Figure 3b: Trailing PE Ratios, Monthly, January 1965-February 2024

Four points are most noteworthy:

1. Both of these ratios peaked immediately before the Crash of 1987: the trailing PE reached 21.1 – higher than at any time since the Poseidon Boom of 1970 – in August 1987. CAPE reached 25.7 in September 1987.
2. Neither measure signaled trouble before the recession of the early-1990s.
3. CAPE flashed red (and the trailing PE amber) during the Dot Com Bubble: from December 1998 to August 2001, CAPE exceeded 22 and rose as high as 25.5 – its highest level since the eve of the Crash of 1987 – in August 2000.
4. One of these measures – CAPE – flashed strong warning signals well before the GFC: from November 2004 to May 2008 it again exceeded 22, and throughout 2007 exceeded 27 and in October 2008 attained its all-time high of 28.5.

Which PE ratio best avoids hefty losses? Which, in other words, imparts the most reliable signals? None is or can be a perfect sentry. Yet CAPE is far superior to the others; the trailing PE is very much second-best, and the forward PE – the mainstream’s pet – is clearly worst.

The forward PE generally emits muddled signals

The forward PE occasionally emits egregiously false information; usually it sends muddled signals. For each month since January 1975 (All Ordinaries Index) and January 2006 (S&P/ASX 200 Index) I computed the relevant Index’s compound annual growth rate (CAGR) during the previous 60 months and the next 60 months); I then sorted the data by the relevant earnings multiple, divided the data into five equal subsets (quintiles) and computed summary statistics for each quintile. Tables 1a and 1b summarise the results.

Table 1a makes logical and empirical sense – and provides the sound basis of value investing. The higher is the All Ords’ trailing PE during a given month, the higher has been its CAGR over the previous five years – and the lower its CAGR will average during the next five years. CAPE provides the same – albeit even clearer – result. The lower is the PE when you buy and the higher when you sell, the better will be your return.

Table 1a: 5-Year CAGRs (Excluding Dividends), by Quintile and Type of Trailing PE Ratio, All Ordinaries Index, January 1975-February 2024

In contrast, since 2006 the forward PE ratio has usually emitted muddled signals (Table 1b). Considering all five quintiles, the higher is the S&P/ASX 200’s forward PE during a given month, the lower has been its CAGR over the previous five years – and the higher its CAGR during the next five years. Quintiles 2-5, however, indicate that a change of forward PE bears no influence upon either the previous or the subsequent CAGR.

Table 1b: 5-Year CAGRs (ex-Dividend), by Quintile of Forward PE Ratio, S&P/ASX 200 Index, January 2006-February 2024

Is the consensus – yet again – prodding the crowd to risk hefty losses?

Given that the forward earnings multiple is by far the least satisfactory metric of market valuation, what does it tell us about the year to come? Surprisingly, something of value – and unsurprisingly, “experts” have completely overlooked it.

In the AFR on 12 February, Shane Oliver also stated “that the slightly higher-than-average forward PE multiple is in the context of benchmark Australian interest rates sitting at a historically high (sic) 4.35%, with the market expecting the RBA to cut (its Overnight Cash Rate) in the second half of 2024 to boost the economy. ‘So (sic) this means shares are priced on the basis earnings will rise.’”

Setting aside the inaccuracy (it’s true that the target of RBA’s Overnight Case Rate is presently 4.35%, but it’s not “historically high” – on a monthly basis since 1990, it’s averaged 4.42%) and the non sequitur (is Oliver really asserting that the mere expectation of lower rates will cause earnings to rise?) I wonder if Oliver – or any analyst, strategist, etc. – has any idea how just much the latest (29 February) forward multiple implies that trailing earnings must rise during the next twelve months.

On 29 February, the S&P/ASX 200 closed at 7,703, and its forward earnings multiple was 16.1. On that date the consensus was therefore that in February 2025 the Index’s aggregate earnings would be 7,703 ÷ 16.1 = $478. On 29 February of this year, the trailing PE ratio was 21.5; consequently, the Index’s aggregate earnings were 7,703 ÷ 21.5 = $358.

The consensus is thus contending that during the next year the Index’s earnings will lift ($478 - $358) ÷ $358 = 33.5%. How plausible is that?

Figure 4: Trailing Earnings’ Rate of Change, All Ordinaries Index, Rolling 12-Month Periods, January 1966-February 2024

Figure 4, which plots the S&P/ASX All Ordinaries Index’s trailing earnings over rolling 12-month periods since January 1966, shows that it’s very unlikely. During the average interval, earning rise 7.0%; and in only 4.1% of them have earnings risen 33.5% or more.

We can’t presently know how close the latest forward estimate figure will be to actual earnings (we’ll have to wait until February of next year), but we do know the extent to which previous estimates have approximated actual earnings. In January 2006, the Index closed at 4,929, the forward multiple was 16.3 and thus the consensus forward estimate of earnings in January 2007 was 4,929 ÷ 16.3 = $303. Actual (trailing) earnings in that latter month were $292. Figure 5 plots the results of similar monthly calculations (which align the two series by matching a given month’s trailing earnings with its forward earnings 12 months previously) since January 2007.

Figure 5: Comparing the S&P/ASX 200’s Actual and Forward Earnings, Monthly, January 2007-February 2024

It’s important to explain the two series’ reasonably close (except during the COVID-19 panic) correspondence. Does it imply that, 12 months in advance, the consensus is generally able to accurately forecast the Index’s earnings? Certainly not! Recall the crucial point in the section above entitled “Which Consensus Estimate Counts?”: analysts constantly revise their estimates of forward earnings for a given point in time; according to conventional practice, a company’s (or market’s) earnings beat (or miss, etc.) the consensus estimate if actual earnings exceed the most-recent forward estimate – which almost always appears after the period in question has concluded.

Given the conventional practice, and as Koller, et al., wryly phrase it, “one would expect analyst estimates at that stage to be accurate.”

At this point it’s important to recall our first conclusion: the Index’s trailing and prospective earnings on the one hand, and its returns on the other, are usually correlated – but they’re anything but consistently correlated. As a result, the average 12-month correlation is effectively zero. We don’t know the course of earnings during the next year; nor do we now know what the trailing and forward PEs will be in a year’s time; but it’s reasonable to assume that the current gross disparity between trailing and forward earnings will narrow. Since 2006, and excluding the colossal disparity during the COVID-19 panic, the final disparity has averaged 4.4% (Figure 6, whose y-axis to a maximum of 50% to improve readability).

Figure 6: Implied Disparity, Trailing and Forward Earnings, S&P/ASX 200 Index, January 2006-January 2024

Specifically, it’s reasonable to suppose that during the next year some combination of two logically equivalent things will occur: trailing earnings will increase sharply relative to the forward earnings estimate for February 2025, or the estimate for that month will fall significantly relative to trailing earnings.

A sharp rise of trailing earnings – which is possible but unlikely – will boost stocks; but a significant decrease of the consensus estimate of forward earnings, which I suspect is much more likely, could remove a key prop from the Index’s current level.

Let’s assume that in a year’s time trailing earnings rise to the average of today’s trailing number and the forward estimate: ($478 + $358) ÷ 2 = $418. That’s very generous: it assumes that trailing earnings will lift almost 17%, which is more than double their long-run average rate of growth.

Let’s also assume that in 12 months today’s trailing and forward PE ratios converge to (16.1 + 21.5) ÷ 2 = 18.8. If so, that implies an S&P/ASX 200 of $418 × 18.8 = 7,858. That’s an increase of 2% from its close on 29 February. On the other hand, if earnings grow by their long-term average of 7%, then they rise to ($358 × 1.07) = $383; assuming a trailing PE of 20.5, that also means an Index of 7,858; but if the PE ratio recedes to its long-term mean (15.2 since 1965, which prevailed as both forward and trailing PEs as recently as June 2023) the Index falls to just 5,822 – a plunge of 24%.

I conclude that today’s consensus is complacent – and perhaps dangerously overconfident. The risk is significant that its estimate of forward earnings – and its valuation of the S&P/ASX 200 – grossly outpaces reality. If so, the sudden recognition of the disparity could trigger punishing losses.

My results corroborate McKinsey’s

There’s a big literature that analyses earnings guidance, consensus estimates of forward earnings and the like. Much of it is arcane and inaccessible for most investors, but three articles are admirably concise, relevant, rigorous and readable:

1. Peggy Hsieh et al., “The Misguided Practice of Earnings Guidance” (mckinseyquarterly.com, March 2006);
2. Bin Jiang and Tim Koller, “The Myth of Smooth Earnings” (mckinseyquarterly.com, February 2011);
3. Tim Koller et al., “Avoiding the Consensus-Earnings Trap” (mckinseyquarterly.com, January 2013).

It bears repetition: analysts, CEOs, investors and journalists believe that companies must at least meet – and preferably beat – beat analysts’ consensus estimate of earnings. They hope that if they produce better than expected earnings then investors will boost their shares. Conversely, they fear that below-consensus earnings will prompt investors to punish wayward companies’ shares – and, by extension, their CEOs.

As a result, senior executives can go to great lengths to meet or beat consensus estimates – even to the point of risking the business’ longer-term health. American companies, for example, commonly offer customers steep discounts in the final days of a reporting period in order to stoke their sales; in effect, they borrow from the next quarter.

Worse, executives might also forgo long-term value-creating investments in favour of short-term results. John Graham et al. (“The Economic Implications of Corporate Financial Reporting,” Journal of Accounting and Economics, 2005, vol. 40, no. 1, pp. 3–73), found that a majority of CFOs “would avoid initiating a positive NPV project if it meant falling short of the current quarter’s consensus earnings.” Worst of all, found Hsieh et al., executives might massage earnings in order to create the illusion of earnings stability.

Koller et al., however, demonstrate that “in the near term, falling short of consensus-earnings estimates is seldom catastrophic. Even consistently beating or meeting consensus estimates over several years does not matter, once differences in companies’ growth and operating performance are taken into account. In fact, a company’s performance relative to consensus earnings estimates seems to matter only when it consistently misses them over several years."

In other words, “the notion that markets reward companies with higher share prices when they consistently beat the earnings consensus turns out to be wrong ... Once adjusted for revenue growth, return on capital, etc., the apparent effect of consistently beating the consensus, which we define as four or more years out of seven, disappears.” Moreover, “companies with strong growth or ROIC had high shareholder returns regardless of whether they consistently beat the consensus. Only those companies that consistently missed it – again, in four years out of seven – showed a statistically significant negative effect from doing so.”

McKinsey & Co.’s research concludes that companies which provide earnings guidance aren’t valued more highly than those that don’t. Companies provide guidance for various reasons – and most of them, says McKinsey, “are misguided. Our analysis of the perceived benefits of issuing frequent earnings guidance found no evidence that it affects valuation multiples, improves shareholder returns, or reduces share price volatility. The only significant effect we observed is an increase in trading volumes when companies start issuing guidance – an effect that would interest short-term investors who trade on the news of such announcements but should be of little concern to most managers, except in companies with illiquid stocks.”

However, “providing quarterly guidance has real costs, chief among them ... an excessive focus on short-term results.”

Given McKinsey’s findings, as well as mine, it’s clear that most companies are wasting time trying to manage their short-term earnings, that analysts trying to forecast them are attempting the impossible – and that investors who heed these analysts and CEOs aren’t just wasting their time: they risk harming their results.

Implications

“It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so,” goes an adage commonly attributed to Mark Twain. “While the whole world was having a party, ... outsiders saw the giant lie at the heart of the economy,” added a voice-to-screen at the start of The Big Short (2015), “and they saw it by doing something (that nobody else ever) thought to do: they looked.” Earthily, pithily and most fundamentally, the movie also demonstrated that “truth is like poetry. And most people f###ing hate poetry.”

In this article, I’m but the latest (David Dreman was the first and remains by far the best) to expose the untruths at the heart of contemporary security analysis. I’ve done what a few contrarian and intrepid investors did before the GFC – and what the mainstream, then and now, never does: examine its most fundamental assumptions.

To the extent that they convey meaningful information, consensus forward earnings quantify experts’ overconfidence – and, at extreme junctures like today, delusion. And overoptimism, in turn, underpins financial error and failure (see also Why you’re probably overconfident – and what you can do about it, 14 February 2022).

Most investors should therefore ignore companies’ earnings guidance and analysts’ consensus of forward earnings. For a conservative-contrarian minority like Leithner & Co., they’re relevant only when their deviation from reality reaches an extreme: at those junctures, they can provide a useful warning indicator.

McKinsey’s results, together with Dreman’s and mine, reveal the rotten foundations of contemporary mainstream security analysis in Australia, the U.S. and elsewhere. Yet just as Dreman’s and McKinsey’s findings haven’t influenced the crowd, nor will mine. The mainstream will take no notice, and it certainly won’t change its ways. That’s because an honest acknowledgment of reality would oblige “analysts” to admit that they don’t possess a reliable crystal ball. Indeed, it's unreliable. 

Perhaps more importantly, many investors want desperately to believe that somebody knows the future – even though, deep down, many of them must surely recognise that nobody does.

Why can’t the mainstream abide these truths? Confessing that there are no gurus – but plenty of charlatans who masquerade as seers – means that investors must squarely face their worst fears. Above all, they must accept that experts’ beliefs about and actions regarding earnings are largely nonsensical and sometimes harmful; consequently, and unlike most experts, investors worthy of the name must think sensibly and independently.

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