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Playing the Earnings Game

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Earnings season is now in full swing, as American corporations begin to report their profits and revenues from the fourth quarter of 2011. Investing professionals recognize that the name of the game is not so much how much a company’s earnings have increased, but the extent to which those earnings meet – or fall short of – Wall Street’s expectations. For instance, when Alcoa reported a three-cents-per-share loss to kick off the season, the company’s stock responded by ticking up a couple of points – because that three-cent loss met the consensus estimate of Wall Street analysts. (Alcoa is traditionally the first major American company to release its earnings report, kicking off each earnings season.)

With so much on the line for their share prices, corporations have become very good at beating those estimates. In fact, historical studies show that 61 percent of all companies beat their consensus estimates during each earnings season. According to research conducted by the Bespoke Investment Group, at least half of all reporting corporations have beaten their earnings estimate in every single quarter since the year 2000.

In other words, a company should be expected to beat its earnings estimates, which means that status is hardly newsworthy. On the other hand, since a minority of companies actually miss those estimates, that presents a much more significant situation. Indiana-based medical-equipment company Hill-Rom announced earnings of just 52 cents a share on January 11, falling just short of the Wall Street consensus of 56 cents a share. The market responded by dropping Hill-Rom’s stock price by 12 percent.

One way in which corporations are able to temper the expectations around them is by issuing pre-announced earnings guidance reports. The Web site has looked at all the companies that offered such guidance in the weeks leading up to earnings season, and found that the ratio of negative-to-positive news averaged 2.3 to 1. More than twice as many companies try to damp down expectations before reporting earnings than those who present good news.

For the current earnings period, companies have become even more pessimistic than that: According to Strategas Research Partners, negative pre-announcements for the just-concluded fourth quarter are outnumbering positive ones by a whopping 3-to-1 margin. If that sounds like bad news, it’s not. That kind of ratio makes it likely that a higher percentage of stocks will beat expectations and get an earnings bump in the market. “The ratio of negative-to positive earnings preannouncements has been a reliable contrarian indicator of market performance during earnings season throughout the years,” Strategas wrote in its report.

Given the way earnings skew toward the positive, it should be no surprise, then, that there are many more stocks that greatly exceed their earnings estimates than those who fall far short. Last October, Bill Barnhart of the Web site YCharts looked at the earnings reports for one week from the third quarter of 2011. He found that 180 stocks during that week reported at least a 10 percent surprise in either a positive or negative direction, but the positive surprises outnumbered the negatives by almost 2 to 1. According to Barnhart, 119 stocks exceeded their earnings estimate by 10 percent, with only 61 falling short by a similar amount.

Interestingly enough, the stocks that greatly missed their estimates didn’t do so because of a lack of analysts following them. The 180 surprising stocks that Barnhart tracked had garnered a total of 1,262 earnings estimates, and 726 of those estimates were for stocks with 11 or more estimates each. The other 536 estimates represented stocks with fewer than 10 estimates apiece. In other words, having more analysts’ filing estimates for a stock does not improve the likelihood that those estimates will be accurate.

For what it’s worth, an analyst at Bank of America-Merrill Lynch looked at all the estimates for the current quarter, and found that they were more closely in lockstep with each other than they had since February 1986. It’s possible that this is because analysts have no idea what to expect, and are seeking the wisdom of the herd. Or it’s possible that companies are very aware of the expectations game, and have effectively signaled their desired estimates.

We’ll find out more by the time the current earnings season ends, roughly around the end of February. There’s no official timing to these things, although they generally last about six weeks long. It can often be a very volatile time in the market, with stocks jumping or falling as much as 20 percent in a single day. Just remember, those movements often have less to do with the strength or weakness of a company, and more to do with how well those companies have played with Wall Street’s expectations.