Actually, Earnings Beats Still Matter

May 9th, 2018

By Blackcrane Capital’s Investment Team

There has been an elevated level of chatter these days related to the reaction of share prices to earnings this reporting season, so we decided to weigh in with a few observations of our own.

With headlines like “Death of the Earnings Beat” and hype around “peak earnings,” analysts seem focused on the notion that companies delivering positive results are not being rewarded with correspondingly higher share prices. And indeed, from an absolute perspective, share prices have not reacted well this earnings season.

The first chart below shows that almost 80% of the S&P 500 index* constituents have beaten nominal earnings per share (EPS) estimates this first quarter 2018 reporting season so far. The second chart illustrates why everyone seems to be so perplexed given the reaction to the news five days after the releases.

Source: Bloomberg, as of 4/30/2018

Source: Bloomberg, as of 4/30/2018. Past performance does not guarantee future results.

To start the discussion, I want to point out that a period of muted reactions following good earnings is a fairly common recurring phenomenon, so there is nothing earth-shattering here. The positive news is that these periods tend to be somewhat temporary in nature, usually following a big run up of optimism into an earnings season or elevated levels of rotation. These periods of muted share-price reactions can be extended a bit longer, but are still ephemeral, especially if the overall economy is noticeably inflecting downwards into a meaningful recession.

The second point worth mentioning is that, although Bloomberg makes it so convenient to pull this data, analyzing nominal EPS beats is simply not the best indicator of true operational performance, and thus, of how share prices should react. Operating profits (OP) or earnings before interest and tax (EBIT) are much more robust metrics to use for this purpose. They’re also much less prone to manipulation. Not to mention, over the past decade or so, OP beats have generated more alpha than EPS beats 80% of the time.

Interestingly and to the contrary of the chart above, only about 30% of the S&P 500 constituents have beaten OP expectations this Q1 2018 reporting season. Logically, it is not surprising why the nominal price change immediately following these results have been underwhelming.

Source: Bloomberg, as of 4/30/2018. Past performance does not guarantee future results.

Digging a bit further, as we do in the graph below, we can see that the market, acting in tune with history, is indeed rewarding true operational earnings beats with alpha, while punishing the misses accordingly.

Source: Bloomberg, as of 4/30/2018. Past performance does not guarantee future results. 

In conclusion, we believe the positive-reaction-to-earnings-beat phenomenon is alive and well. Although roughly 80% of firms did in fact beat EPS expectations during the Q1 2018 reporting season, only 30% beat on operational earnings, which implies that a significant portion of the EPS beats were not backed by true operational fundamentals. This is probably the real driver behind why market participants have been so underwhelmed this reporting season.

Happy investing!

 

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*The Standard & Poor’s 500 Index (S&P 500) is a market-value weighted index of stocks issued by 500 large-cap U.S. equities.  It is seen as a leading indicator of the performance of the large-cap universe and common benchmark for the U.S. stock market. Alpha is a risk-adjusted performance metric which measures excess returns of an investment portfolio relative to the returns of a benchmark index. Earnings per share is a company’s profit divided by its number of common outstanding shares. Earnings per share serves as an indicator of a company’s profitability. One basis point (bps) is equal to one hundredth of one percent.

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These results do not represent actual, theoretical, or simulated returns of any Blackcrane Capital, LLC product or strategy.  The data in this post is an analysis of equity share price movements during certain periods of time, and does not represent an investment or trading strategy.  No representation is being made that any account will, or is likely to, achieve profits or losses similar to these being shown. This analysis was developed with the benefit of hindsight, which may allow the security selection methodology to be adjusted until past returns are maximized.  Equity returns and alpha generation may differ significantly from the data presented here based on the time period and macroeconomic conditions of the analysis, and results in future periods may also differ significantly.  The calculations of security returns and positive alpha generation use assumptions that are impossible to replicate in an investment strategy, such as perfect foreknowledge of earnings results.  An actual investment strategy implemented during the periods of this analysis would have relied on the decision making and forecasting of the investment advisor, which may have resulted in significantly different returns than those presented here.  The returns of any investment strategy will also be reduced by the impact of advisory fees, trading costs, liquidity impact, taxes, and other expenses not included in this analysis

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