Ramblings of a Portfolio Manager

Will Santa Deliver an Early Christmas Present or Will a Turkey Fall Down the Chimney?


Earnings season officially kicked off last week with the turn of the calendar, although we have already heard pre-announcements from several companies. As has been the tradition for years now, the preannouncements came ahead of the regular reporting season (by definition, duh!) and carried no particular good news—Company Management has long been cowed by litigation to release the bad news as soon as it is discovered and accurately calculated, lest they be sued for of hiding it from shareholders. So the routine, for a long time now, has been for the markets to receive the bad news first, react to that bad news (usually a negative reaction—after 15 years of Reg FD most investors still haven’t figured out this pattern!), then have the comprehensive news follow during the regular reporting season. Typically that data is better than the preannouncements (again, definitionally) and the markets react to that data depending upon its current mood. That’s certainly what happened last quarter.

We expect nothing different behaviorally for the third quarter reporting season vis-a-vis past trends. The questions, as always, are, what percentage of the reports will be negative pre-announcements, how many will match recent the urban myth of “light on revenues, better on bottom line” and what percentage will actually surpass all metrics pre-cast by the analysts? Yes, this is the question we and the markets ask every quarter, particularly since the market bottom in March 2009, but forgive us for asking it again, given its importance in market performance going forward. And besides, we wanted to get it in ahead of CNBC, which will repeat these lines at least 1543 times between now and November 15th, as always, forgetting that retailers’ reports come one month later.

So what to expect when you are expecting (royalties already paid to the baby book authors)? First, let’s explore what the few market watchers that have publicly spoken on the subject have been saying. Despite better than expected reported statistics and higher than expected guidance last quarter (which did nothing more than temporary for the markets) analysts are still calling for earnings misses and weaker guidance. Their reasoning? Q3 encompassed July and August, two critical months in the European debt crisis and the US ”soft spot.” So, naturally, the expectation is for weak results (perhaps weather than forecast) with soggy guidance (don’t they get that they, themselves, have already baked that fact into their numbers? Guess not). Sounds exactly like the forecast for Q2 earnings, the reality of which stubbornly didn’t comply. Is that how it will be again this time ‘round? And what will be the market reaction? Addressing the first question, we think not. As we have continually stressed, Company Management has learned from years of playing the “beat and raise” game to lower the bar to an appropriate level that can be easily hurdled without seeming suspicious. Nothing we heard last earnings season suggests that we will get anything different this time around—despite the beat and raise environment we had in Q2. No manager on a Q2 conference call was about to stick his neck out given the environment at the time so we feel confident that this fact, combined with the usual conservative game theory behavior in which managers quarterly participate, will produce yet another round of 70%+ earnings beats, given that analysts simply take Management numbers to form their own forecasts. What about guidance? Here again, we expect the same. In fact, the Company Management with whom we have spoken recently are getting more optimistic in light of expected mid-term regime change and may, in fact, be emboldened enough to say even more positive things about Q4 and beyond, especially on the hiring front—and this is despite the political affiliation of the manager (we always ask).

Market reaction? We’re tempted to flippantly (pun intended) suggest one “flip a coin.” Even though the expectations are for weak reports and guidance, the opposite may not have the expected reaction in equity prices. They didn’t, on net, during Q2 (July having been taken back in August) so what has changed that will produce a different result in October? Well, for one thing, the [very] long term data suggest that better than expected earnings reports and guidance produce stock price gains overall and alpha specifically for those companies producing it. A couple of quarters during which the markets are in a sour mood and choose to ignore that fact are statistically insignificant. This doesn’t mean October will fall in line with history, however. What we believe will give the markets a boost on better earnings in the next few months is rising investor optimism. When Q2 earnings were reported in July, investor sentiment could not have been worse and even though we got a temporary run in stock prices, the tug-of-war with macro economic data ended with macro winning and tamping down the enthusiasm and, thus, stock prices. But this quarter is different. We have investors looking optimistically toward the upcoming elections, others looking at their underperformance and realizing that further investments in 10-year Treasuries just aint gonna beat the competition, and still others looking at 2011 as the year Obama’s damage is softened by a new congress while the economy continues to heal on its own. Like us, this last group has seen productivity gains slow and capacity utilization additional reach cap-ex levels, and both recognize this means jobs and further economic growth down the road.

So, to answer our own headline question, we thing Santa comes early this year and that the turkeys will be sucking gravy come earnings season.