Ramblings of a Portfolio Manager

Mr. Peabody’s Apples

The dog days of summer are upon us so we’ll spare you a lengthy treatise on some arcane aspect of finance. Instead we’d like to talk about a little children’s story, written by Madonna of all people, that we used to read to our kids. It’s based on an old Eastern European folk tale of a woman who spread a false rumor and the village wise man who challenged her to shred a feather pillow into the wind and then try to recapture all the loose down, the moral being that once out false rumors and gossip are almost impossible to recall. Sound like the internet? Sounds a lot like CNBC to us as well.

OK, confession: what we really want to do is give you a quick report card on the current earnings season to date. So far approximately 1/3rd of S&P 500--and by extension all US--companies have reported their second quarter earnings. Going into this reporting season the general consensus among the Wall Street sell side and financial media was that the second quarter reports would be good, but not great, and that management guidance would be terrible, given the turmoil in Europe and engineered slowdown in Asia. How did that consensus belief come into being? Cynically, we suspect that it originated from a Wall Street sell side analyst who was unable to update his Q3 and 2011 earnings models because the managements of companies he followed refused to spoon feed him the correct numbers. In any case, however it began, the financial media picked up the story and repeated it ad naseum, without any attempt at corroboration or even sanity test, until it became an accepted fact—it all just made so much sense (to them, anyhow).

Fast forward a month and where are we? Well, by our calculations, 78% of the companies reporting so far have beaten Wall Street earnings estimates with EPS up 42% year-over-year versus initial expectations of 27%--i.e. 15% better than forecasts. That’s almost 10% higher than the average “beat” rate since 1998. As for guidance, at least 10% of companies that have reported so far have raised guidance, 2% have lowered it with the rest maintaining their outlook for the rest of the year and into 2011. Doing the tough math, that’s 98% of reporting companies NOT seeing the future in the same way as the sell side or financial media. By the way, according to Bespoke Investment Group (whose numbers differ very slightly from ours), that’s the highest percentage spread of up vs. down guidance since 2001 and the fifth consecutive quarter where positive guidance has outnumbered lower, the longest streak since 2001. And how are the analysts and media reacting to this reality? Well, some of the feathers are back in the pillow, but the perception remains and the talking heads still manage an ominous “What will management say about the future?” at least once a day when mentioning companies due to report. In addition, beaten but not out, financial reporters, who obviously haven’t read the Mr. Peabody parable (do they even read?) have started yet another rumor: this one goes something like “While the earnings have come in better than expected and guidance has been strong, most companies have missed or not beaten on the top line.” This amounts to an admission of “Well, we may have been wrong about the first rumor but, surely, two pillows will need not be restuffed…?”

So with all the hand-wringing about the top line, what does the data say? Stuff it Baby! According to our data and others, revenues have largely followed earnings with 73% of reporting companies beating top line expectations to date, a number also well above the historical average. In fact Reuters just last week raised its year-over-year revenue growth expectations from 9% to 9.5%. While the percentage “beat” has not been as great on the top as the bottom line (5% vs 15% for EPS), the data is still in direct conflict with what we hear daily in the media. Yup, the financial media’s reaction to this fact has been to throw out the pillow entirely--to simply ignore facts and continue with the mantra of “Revenues just aren’t living up to expectations.” We suppose it makes for better headlines than “We Was Wrong!” So, in answer to our question above, no, financial reporters don’t read…or at the least they can’t read earnings reports. It’s a good thing your first grade teacher wasn’t also a financial reporter—with their ability to analyze report cards, you’d still be repeating that grade.

This morning the brains on CNBC are reporting that 1/3rd of S&P 500 companies are left to report. It appears that retailers, on a one-month lagged fiscal year, no longer count in Medialand. We wonder if any attempt will be made to return these feathers. Doubtful. As we tell our kids while they watch cartoons, “don’t believe everything you see on TV…except, for course for Spongebob.”

On next week’s installment of Misconception Becomes Mantra : How 50.6% of the stimulus package having been spent so far amounts to “almost all of it” when it hits the airwaves.