Practical analysis for investment professionals
25 June 2015

Earnings Estimates and Investment Decision Making

Earlier this week we polled CFA Institute Financial Newsbrief readers, asking, “To what degree do earnings estimates factor into your investment decision making?” Of 388 respondents, about 62% do, in fact, make use of earnings estimates in their work. Just under half of those who do use earnings estimates say they “significantly” factor into their process.

Passive investors have little reason to utilize earnings estimates, so presumably most of those responding to the poll are active investors. Currently active investors are enduring a high-pressure moment from clients, exchange-traded funds (ETFs), and the passive investment community. The perception, of course, is that there is little value-add brought to the client equation by active investing. Today, CFA Institute is hosting a Future of Finance online forum to discuss the future of active management.

Could it be that one source of alpha bleed is an overreliance on earnings estimates? After all, earnings have a poor history of predictive power for future equity returns as demonstrated by many studies. Also, earnings estimates may anchor active investors to some potential bad habits, such as:

  • Short-termism
  • Lack of independent judgment
  • Higher turnover/higher trading costs

To what degree do earnings estimates factor into your investment decision making?

Earnings Estimates and Investment Decision Making


Short-Termism

Does using earnings estimates create a mindset among investors that what happens in the upcoming quarter or year earnings-wise is important? Does making or missing a quarterly number really matter to the health of a business over the long term?

For example, I remember Costco (COST) missing a quarterly earnings number in May 2000 by a negligible amount ($0.01–$0.02) due to its having completed construction of several stores ahead of schedule. In turn, that meant that its pre-opening costs for new facilities increased — hence the earnings miss. Yet, long term, this was a great development for the business. Shares fell over 20% in one day, and over the course of the next two days the firm for which I worked became Costco’s largest shareholder. As a long-term investor, the firm understood that the earnings miss was actually good news for the business, if not for the stock.

Lack of Independent Judgment

In my experience, most investors do not create their own earnings estimates. At best, they tweak the consensus earnings estimate to reflect their unique view of a company, or investors tweak their favorite sell-side analyst’s estimate for a business. But at worst they just plug the consensus into their decision-making process. All of this is fine if an investment company consistently generates returns exceeding its benchmark.

Could it be that there is too much groupthink in investment decision making, groupthink driven, in part, by orienting the research process toward a single number — the earnings estimate? Even those active investors who create their own valuation models frequently check the model’s quality by seeing if it can generate the quarterly earnings estimate number within the consensus range. Many also check their models with the management of the businesses they are evaluating to ensure it is “correct” relative to future earnings. Where is the independent judgment?

Higher Costs

Presumably people are using earnings estimates because they believe them to be critical to the investment process and hence contain actionable information. If so, then they are likely to trade on this information, too. Yet because of commissions, more trades equal more alpha drag. Also, some may trade more to pay back sell-side firms for their “research” and the earnings estimates that are central to that research. Again, this would be fine if an active manager could point to a track record of success. But competing with frictionless benchmarks means that any active management cost must be made up by superior discounting.

Better Earnings Estimates

If investors remain committed to using earnings estimates, at least to some degree, then perhaps a variety of opinions would lead to a more robust understanding about the future prospects of a business. Statistical research has demonstrated that crowd-sourced earnings estimates, such as those provided by Estimize, are superior to those offered by sell-side firms. Another company providing access to independent assessments of earnings in competition with traditional sell-side firms is SumZero.

In conclusion, it isn’t that the use of earnings is necessarily bad. But active managers need to engage in some introspection to put out the critics’ flames. Overreliance on earnings estimates may be a good place to start.

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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

About the Author(s)
Jason Voss, CFA

Jason Voss, CFA, tirelessly focuses on improving the ability of investors to better serve end clients. He is the author of the Foreword Reviews Business Book of the Year Finalist, The Intuitive Investor. Previously, Jason was a portfolio manager at Davis Selected Advisers, L.P., where he co-managed the Davis Appreciation and Income Fund to noteworthy returns. He holds a BA in economics and an MBA in finance and accounting from the University of Colorado.

Ethics Statement

My statement of ethics is very simple, really: I treat others as I would like to be treated. In my opinion, all systems of ethics distill to this simple statement. If you believe I have deviated from this standard, I would love to hear from you: jason@jasonapollovoss.com

7 thoughts on “Earnings Estimates and Investment Decision Making”

  1. Ibrahim Masood says:

    It would also be interesting to conduct a similar survey on beliefs about relvant variables that drive/predict future investment returns. I wonder how many practitioners are actually aware that earnings estimates have no correlation with future returns, by extension forward earning multiples are also not correlated with future returns, and even trailing multiples have very weak correlations with subsequent returns for periods upto even 3 years. Its all well and fine blaming clients for the focus on short term returns, yesterdays winners etc but surely an industry that as a majority (62%) incorporates spurious variables into their decision making process is bound to come up with modest results, at best.

    1. Hello Ibrahim,

      Thank you for your thoughtful comments. To your point about the correlation of earnings to future stock returns, here is an excellent piece written by Vanguard that was a test of many of the common predictors of future earnings that I think is pretty robust: https://personal.vanguard.com/pdf/s338.pdf

      Also, I have to declare that I am an unflinching advocate of active management. However, I do believe the active management community needs to engage in some introspection to improve its offerings. I also believe that the passive community and its advocates use some spurious measures of their own. But more on that another time.

      Yours, in service,

      Jason

      1. Ibrahim Masood says:

        Dear Jason;

        Thank you for your response. I am with you 100% on being a supporter for active management, but the issue with active management is structural in my opinion. The measurement of performance on time periods as short as a couple of quarters focuses attention and efforts by practitioners on generating returns over time periods where price movements are pretty random. Investors who reward recent short term performance, also play an active role in encouraging practioners in chasing performance over the short term. I recall a fantastic stat quoted in a televesion interview by a hedge fund manager who said the best performing US mutual fund over the last 5 years had the average investor in the fund actually losing money after fees because of the churn. That was a really incredible factoid I thought.

        I found your article interesting and thought provoking, hope to read more from you in the future as well.

  2. Great thought leadership!

    So 70% of respondents say they are significantly or somewhat significantly influenced by earnings estimates.

    Despite all the talk about long-termism and fact that ESG friendly investors now account for more than 50% of the institutional investment market, these figures speak for themselves. And let’s remember these are self-assessments with all the bias that comes with this.

    And yet, ask a buy side analyst or fund management firm if they pay a lot of attention to sell side research and the answer is always a clear and unequivocal “no”!

    What’s the way forward?

    One answer – as with drugs – is to find less damaging substitutes. You highlight some alternatives to traditional sell side research, which would give investment users a cleaner, safer and cheaper hit.

    Certainly, substitution of methadone for heroin can be a step forward if it’s part of a controlled therapeutic programme. But the real answer is to kick the habit, which means find people who want to do the same thing.

    The investment industry needs it own 12 step process! But do the voluntary reform initiatives really serve this purpose? Until we get this, we seem well on track for more and more preventable surprises.

    1. Hello Raj,

      Thank you, as always, for your considerate points of view. My own preferred analogy here might be to sugar or to fat, rather than to heroin. Sugar and fat are part of the nutrients each of us eats, but must be part of a well-balanced diet. When taken to extremes the imbalance leads to addiction, and to health problems. To my mind, earnings are fine as an ingredient into the research equation. But when there is over-reliance on them there are health effects such as those I outlined above.

      I would be interested in your thoughts – since you are on the frontlines of many an important investment conversation – as to what progress you feel has been made in the last 3-5 years on some of the issues I raise here, and that I know you care about, too.

      Yours, in service,

      Jason

  3. Thanks Jason. Nice challenge!

    I’m happy to go with sugar analogy, so long as we include the way that industry (sugar/processed foods) has added it whenever and wherever it could (and shouldn’t have):

    http://www.telegraph.co.uk/lifestyle/wellbeing/diet/9160114/The-bitter-truth-about-sugar.html

    But back to the dysfunctional research supply chain…are things getting better? Well the CFA Institute is writing about the situation, so definitely that’s a healthy sign!

    And in practice? Take the investor debacle over Tesco. All the signs of a preventable surprise and once again, investors rewarding executives for doing the wrong thing. And on this occasion one brave sell side analyst team even stuck their neck out. But to no avail – the noise of the consensus was overwhelming:

    http://www.ipe.com/analysis/long-term-matters/long-term-matters-lost-on-tesco/10004110.fullarticle

    So knowing all we know, with long-term/responsible investors apparently accounting for over 50% of the market, are investment firms learning and getting out in front? For example, supporting unbundling so that we can have rational research markets? You’d think firms that know how to value everything in the corporate world would know how to value research, no?

    Well, in the EU, many firms are fighting a rear guard action under the cloak of trade bodies:

    http://www.ft.com/cms/s/0/22bc844c-1d74-11e5-aa5a-398b2169cf79.html

    And in the US, unbundling is not really on the agenda, presumably because the regulators know what’s “possible”.

    I’d be interested to hear from others too.

  4. Hi Raj,

    Thank you for filling out the discussion with your thoughts. I would also love to hear from other folks.

    Yours, in service,

    Jason

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