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Do earnings 'beats' and 'misses' really matter?

Karen Wallace  |  03 Aug 2021Text size  Decrease  Increase  |  
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Reader question: I'm somewhat new to stocks. How much attention should I pay to quarterly earnings reports? 

Answer: Pay attention to a company's short-term results, but weigh them in a longer-term context. 

As a shareholder, you should expect half-yearly earnings to follow a certain trend line over the long term. You can be satisfied if the company you own is staying within that trajectory. It makes sense to have an expected range within that trend, making sure it's wide enough to account for the volatility one would reasonably expect in that sector or industry.

That said, it's also possible for a company to show you a few results that lead you to reconsider your original thesis. For instance, maybe a company is strapped for cash for a few quarters, and that leads it to take on pricey debt to fund operations down the line ...

Earnings results are important because they inform your longer-term views, but they are only one data point among many. Here are some other things to consider.

The short- and the long-term view

Picture two card players. One player is focused on the short term and whether or not a stock will beat analysts' quarterly earnings expectations. This player might double down if a company beats earnings forecasts, or sell quickly if it misses expectations.

The other player is focused on what those quarterly results mean in the context of a multiyear trend. This player has a big advantage, but the price of that advantage is patience, which is too steep an ante for most players. 

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Whereas short-term returns are driven by random factors, longer-term returns are driven by things that are more predictable, like dividend yield, earnings growth, and inflation. As explained in this interactive Morningstar Investing Classroom lesson, "The Purpose of a Company," over shorter periods of time, there can be a disconnect between how a company performs and how its stock performs. This is because a stock's market price is a function of the market's perception of the value of the future profits a company can create. Sometimes this perception is spot on; sometimes it is way off the mark. 

Over longer stretches, though, the market tends to get it right, and the performance of a company's stock tends to mirror the performance of the underlying business. That's why a long-term investor has an advantage: Short-term results are anyone's guess, but it's possible to predict a company's longer-term financial performance if you carefully consider fundamentals like previous financial results and performance drivers, guidance from company management, industry data, tax rates, risks to the business, competitive advantages, and more.

When a miss is not cause for alarm

Quarterly or half-yearly earnings reports can be a window into how well a company is tracking with your long-term expectations, but investors should be aware that they are not always going to be in a straight line.

Real life is lumpy. You may even need to readjust your long-term expectations as a result of some near-term news. But in the absence of thesis-shattering developments, an earnings miss is not necessarily an indication that it's time to jump ship. 

For instance, even when a company misses consensus estimates by a considerable margin, you can look beyond the headlines to find clues as to how well a business is managed. In this way, an earnings miss can give you insights into how well a management team executes when it comes to things they can control, as well as how well it responds to things that are outside of its control.

Sometimes an earnings miss and the resulting sell-off can be an opportunity for a shrewd long-term investor to pick up discarded shares of high-quality companies at a discount. For example, as my colleague Dave Sekera explained, "in-person" consumer stocks, such as brick and mortar retailers and shopping malls, restaurants, and travel stocks, were hit especially hard during the pandemic because of safety and operational restrictions. 

But we viewed the sell-off as overdone in many cases--last fall, for instance, we forecast that as the economy returned to normal, travel, restaurant, and retail operations would all pick up steam again. Indeed, restaurants, airlines, and retailers have all rebounded strongly over the trailing 12 months. 

When to re-evaluate your thesis

One earnings report is usually not sufficient to throw in the towel on a company you have high conviction in. However, it's possible that a bad earnings report is an early warning sign of deteriorating fundamentals. 

It pays to look at it through the lens of what you expect over the long run and objectively evaluate a company's competitive position and growth prospects in the industry in which it operates. Sometimes things change, and you have to incorporate that new information into your thesis. 

For instance, in 2020, senior equity analyst Jaime Katz downgraded Carnival's (CCL) Morningstar Economic Moat Rating to none (from narrow). As the largest cruise operator, Carnival has historically benefited from its brand intangible asset, cost advantage, and efficient-scale moat sources. However, Katz believes these factors have largely been degraded.

Not only has global travel waned as a result of coronavirus, but the pandemic could also have lasting negative effects on Carnival, such as pricing pressures, operational challenges, and longer-term secular shifts in consumer behaviour away from cruises. Katz believes these concerns should lead to average returns on invested capital that are below our weighted average cost of capital estimate until 2028, supporting a no-moat rating.

Putting it all together

One oft-repeated tip is to write down the reasons you bought each stock in your portfolio, and your thesis for continuing to own it. Though it may sound ridiculously simple, I've heard this advice repeated by many investors, advisers, and even professional money managers.

We're human beings first and investors second; we can get spooked by bad news and want to jump ship, even when our original thesis still holds true. Alternatively, we can become attached to investments that are no longer tracking with our long-term expectations, perhaps because we're interpreting new data through a lens clouded by confirmation bias. Having a record of why you originally bought a stock and your expectations for it can help you objectively evaluate earnings reports with a long-term view.

is a senior editor with morningstar.com.

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