Columns

A surprise in the making

Deirdre McMurdy May 10 1999
Columns

A surprise in the making

Deirdre McMurdy May 10 1999

A surprise in the making

Columns

Deirdre McMurdy

It has become one of the annual rites of spring: the first robin, the first primrose, the

first quarterly corporate earnings. At a time of extreme market volatility, investors scrutinize every scrap of available information, looking for clues to future performance. The Internet, 24-hour news channels, and the proliferation of business publications help in this relentless quest. But increasingly, traditional indicators like quarterly earnings have become distorted and irrelevant.

Companies are so anxious to avoid the downdrafts of shareholder disapproval that they now over-manage expectations. While it is responsible to temper excessive optimism about stock, there is a fine line between such management and manipulation. An increasing number of businesses lowball earnings estimates, revenue projections or sales forecasts so they can manufacture a “surprise” round of better-thanexpected profits—and score points with the market. “Its hard to actually prove how much of this is deliberate,” says Subodh Kumar, portfolio strategist at CIBC World Markets. “But there has been a coincidence of ‘better-than-expected’ performances in the last three or four quarters.”

Certainly the illusion of superior performance has dominated this year’s first quarter results. Company after company appears to “beat the Street,” reporting earnings that exceed analysts’ forecasts. Among them are industry giants like IBM, AT&T and Microsoft, as well as a handful of Canadian forestry firms. Last week, White Rose Crafts and Nursery Ltd. recorded a 22-per-cent drop in sales, but that was hailed as an accomplishment because it exceeded expectations by almost five per cent. At Dofasco Inc., profits were down six per cent in the first three months of the year. Again, the victory of “better-than-expected” results was declared.

For investors, earnings—and earnings forecasts—are traditionally regarded as fundamental components of financial analysis and the basis for investment deci-

sions. To develop their earnings models, industry analysts crunch wads of public infor-

mation. But they still rely heavily on guidance from corporate management when formulating their estimates. The machinations to create positive earnings “surprises” are not at odds with the analysts’ agenda either: they tend to favour results which allow them to issue “buy” recommendations to their clients—and generate trading activity. Of the 30,000 recommendations covered by First Call, a firm that tracks analysts, fewer than one per cent advise investors to sell rather than buy or hold a market position.

Another way many companies effectively distort their earnings is by buying back shares. A reduced public float means earnings are distributed among fewer hands— another tactic to boost share price and earnings per share without improving performance. Last month, in a bid to bump up stock price, Second Cup announced plans to purchase its own shares, which were trading at $14.75, for $16 each.

While equities are not drying up, market liquidity is diminishing. In 1998, $175 billion (U.S.) in equity was removed from American exchanges because of merger, acquisitions and share buyback programs. In Canada and the United States, investors have focused narrowly on the large capitalization, blue-chip stocks leading the latest bull market rally. As a result, initial public offerings—unless they are in Internetrelated ventures—have not replaced equity taken out of the system. Because low North American interest rates are essentially holding capital captive in stock markets, the strong demand for dwindling supply is artificially sustaining share prices.

The ultimate proof that earnings have lost their edge as an effective tool for measuring corporate performance is the recent record of Internet stocks. Their valuations have soared despite the fact that, in many cases, they have no earnings at all— managed or otherwise.