As an absolute return investor, it’s very important to limit mistakes. One mistake that can be made when valuing a business is taking overly optimistic management projections as fact. This goes beyond the second half story we touched on yesterday. Sales and profit margin goals can go out several years. As an analyst hungry for ideas, it can be tempting to plug aggressive assumptions in a valuation model in an attempt to manufacture investment opportunity.
In a corporate world addicted to the use of non-GAAP adjusted earnings and pro-forma earnings going out to 2017, 2018, and beyond, it’s becoming increasingly important to determine if projections are achievable. Making this task more difficult is the fact that there are a lot of good salespeople in corporate America, and on Wall Street for that matter. Many of these great salespeople make their way up to the top of the management structure and become CEOs. Charismatic CEOs are likable, great story tellers, and easy to believe.
How can absolute return investors combat this? Time is my favorite weapon. The longer a business has been in existence, the more actual results are available that can be compared to previous management predictions. Does management have a history of telling the truth and providing realistic guidance? This is one of the reasons why I like established companies, many of which have been around for several decades. Following businesses over many years also helps an investor properly read the person distributing the spin. Over time I’ve learned which CEOs tend to tread conservatively and which CEOs have won academy awards for their role in giving financial projections.
Some CEOs are just born this way. You can’t stop them. They can’t help it and they just love to sell. This is fine from a business perspective as it probably means they’re good at selling their products or services. However, from an investment perspective it’s the analyst’s job to be aware of the CEO’s powers and adjust their valuation variables accordingly.
Another defense against financial spin is asking for examples. I’ve found superheros of spin do not like giving detailed examples — it’s their kryptonite. It interrupts their script and it’s just not exciting theater. They might have one or two examples prepared, but if you keep digging, don’t be surprised if the charismatic CEO hands the question over to the boring CFO. For example, when a business has a 15% margin goal by 2020, ask specifically why they’re confident margins so far out into the future can be predicted accurately. And don’t take generalizations for an answer. The great spinners will go on and on without talking specifics. If they say synergies, ask for specifics. If they then say back office consolidation, ask for more specifics. Don’t be surprised if it ends there, but then you’ll have your answer. If detailed and quantifiable examples cannot be given, I believe it’s better to rely on proven operating metrics such as historical (over a cycle) profit margins and cash flows.
The above also applies to the asset management industry. For those of you that are fund shareholders and interview fund managers, I suggest doing the same. Grill your portfolio managers on their holdings and you’ll soon learn how involved the managers are in running the portfolio. Ask for specifics rather than accepting broad generalizations like “we’re focused on quality stocks” and “we’re defensively positioned”. Given how expensive quality is trading today,I’d have a field day with that one. In any event, as holding stocks and bonds become more and more difficult to justify, I suspect Wall Street’s spin levels will increase along with asset prices.
I didn’t intend to talk about corporate spin again today after touching on the second half recovery story yesterday. However, after reviewing today’s earnings reports, I found a couple good examples of what I was discussing yesterday. This reminded me of the importance of asking management for examples so I thought I’d discuss.
Yesterday I talked about the second half story and when it isn’t achievable management will often guide earnings lower. Shortly after, the company will then beat the lowered guidance and the stock will go up. I know this doesn’t sound logical, but it happens frequently in today’s warped markets. It happened today with Werner Enterprises (WERN). Werner is a trucking company with a nice balance sheet that I’d actually consider owning at the right price. On June 20 they reduced earnings guidance to $0.21 to $0.25 for the second quarter. Analysts at the time were expecting EPS to reach $0.40, so this was a big disappointment. Today Werner announced actual EPS of $0.25 which was at the high end of guidance and beat analysts’ lowered earnings estimate.
When Werner preannounced its poor results after the market closed on June 20, its stock was at $24.68 and fell to $22.31 the following day. Today its stock spiked higher on its “good” earnings report and ended the day at $25.26. So Werner’s stock was up today above where it was before they preannounced poor results. All of this because it won the “beat the earnings estimate” game even though the estimate they beat was lowered significantly a month ago. And to be clear, it wasn’t a good quarter. Results were poor due to soft freight demand (sales down -7% and earnings down -43%). The company acknowledges this in their earnings release, “Second quarter 2016 freight demand was significantly softer than freight demand in the second quarters of the prior two years.” Sounds like bad news doesn’t it? Not in this market — Werner’s stock increased 5% today.
Watsco (WSO), a leading distributor of HVAC equipment, also provided a good example of the second half story. Although Watsco actually lost the earnings estimate game along with reporting weak Q2 results (small declines in revenue and earnings), management offset this bad news by making positive comments about performance in July. Despite weak results, investors looked to the future (the second half) and drove Watsco’s stock up $2.
There were several more earnings reports Friday that I’d like to discuss, but I went on longer than normal today so I’ll stop here. Overall I thought earnings today were a little weaker than earlier this week; however, I thought investor responses have been much more positive than I’d expect given results. We have a long way to go in earnings season, but so far it’s been mixed at best.