Optimism Everywhere – A Look at the S&P 500
Last week, on the suggestion of several clients, we followed up on our research on the underperformance of Industrials and Basics companies where managements are too optimistic about earnings growth, by extending the analysis (at a 30,000ft level) to the rest of the S&P 500, looking both at the universe in aggregate and the main S&P subsectors.
In that analysis we omitted an analysis of 2013 expectations, but it is interesting to note that the S&P 500 optimists have 2013 EPS growth estimates that are wildly more optimistic than history would suggest appropriate, while the conservative group remains marginally conservative on the same basis.
In the published research we found essentially the same results that we found for the Industrials sector – optimists underperform. Those companies that habitually disappoint on earnings, by setting expectations too high, either implicitly or explicitly, generate lower returns on capital and lower shareholder returns versus those who appear more conservative in the outlook and generally see positive revisions.
The analysis works – sometimes better than others – for every S&P sector except Energy. The conclusions summarize as follows:
- For the overall S&P 500, the optimist group has a 10 year average return on capital of 8.7%, while more conservative group has an average of 12.4%. Neither group has seen much growth in return on capital in the last 10 years, with both trends incrementally positive.
- Taking out Financials, the optimists have seen an average of 7.6% EPS growth from 2002 to 2012 while the pessimists have an average EPS growth of 13.3%.
- The optimists have a total shareholder return that is roughly 50% of the pessimist group excluding Financials and it falls to 36% if we include Financials.
- The optimist group spends marginally less as a percentage of revenue on capital spending and quite a lot more on R&D – mostly this is a Healthcare effect.
- The analysis is complicated by the Financials sector, as you would expect, given the near bankruptcies that we saw in 2008 and 2009, as well as the write downs and the Government intervention. Despite this however the trend is still seen within this sector.
- The analysis does not work well in Energy, as the swings in commodity prices tend to overwhelm everything. For Energy, the optimists spend a lot, but have good EPS growth: they underperform however on return on capital.
- Unlike Industrials and Basics, where we showed that the optimists did not necessarily outspend the more conservative companies, there are plenty of examples in other sectors where they do – most notably, Healthcare (driven by R&D).
We are only looking at the subset of the S&P 500 that has consistent earnings and estimate data from 2002 – this move cuts out about 80 companies. We then lose the five most extreme optimists and pessimists (conservative) from either end of the list – so we are looking at a pool of around 410 companies. In addition we should note that we are defining the S&P 500 constituents are those as of today.