Over-confidence Drives Underperformance

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Graham Copley / Nick Lipinski



December 10th, 2012

Over-confidence Drives Underperformance

  • We follow on from the estimates analysis pieces of last week and look at the possible consequences of not understanding or admitting to real underlying growth prospects.
  • Simply put, companies that overestimate their core earnings power underperform those who do not. Moreover, they underperform on almost any metric you choose to consider.
  • This is a much easier analysis to do on a company by company basis than on a sector basis as all sectors have examples of the more bullish and the more conservative. We have created an optimist group and a pessimist group (20 companies in each) and we look at trends for each group. The optimist group contains constituents from all sectors except Conglomerates; the conservative group is dominated by Capital Goods – on a sector neutral basis we get the same results.
  • The more conservative group does not spend less that the optimist group – they either have projects with better returns or they manage the process better. Alternatively they may have a better understanding of the growth trajectory of their underlying businesses and give more appropriate guidance as a consequence.
  • How the optimist group fares relative to the pessimist group is summarized in Exhibit 1.


Exhibit 1

Source: Capital IQ and SSR Analysis


Generally optimism is seen as good thing, in everyday life and in many aspects of business. Here is a compelling example of where it isn’t.

Following on from the piece we wrote last week about companies’ and sectors’ abilities to forecast their own trend growth rates, we look at the consequences for those that are not “self-aware” and either underestimate or overestimate the strength of their business and their industries. Again we assert that New Year estimates are more a function of company guidance than sell side acumen, as much because of the averaging process as because of risk aversion on the sell-side. We also assume that companies do not guide to earnings that they know they cannot meet and so we assume that consensus estimates reflect a conservative view of what companies think is likely. In exhibit 2 we repeat the table that we showed last week, which gives the 5 and 11 year average of result versus estimate. We take the view that any one year is subject to significant volatility (mostly outside any individual company’s control), but that a longer-term average should reflect the underlying view of trend earnings growth. The table shows that the Capital Goods sector is an under-estimator and that both Packaging and E&C are over-estimators.

Exhibit 2

Source: Capital IQ and SSR Analysis

Obviously giving the right external view of the growth potential of a business matters from a revisions perspective as generally negative revisions result in negative stock performance, but does it matter otherwise? To test this we postulated that over-estimators would overspend as they would over-estimate investment returns – this in turn would negatively impact return on capital, earnings etc.

The results by sector are conclusive where we have a large enough sample group, such as Capital Good or Chemicals. To test the thesis more broadly we created an optimists group and a pessimists group, consisting of the twenty companies who overestimate earnings the most and the twenty who underestimate the most. The list of companies – in alphabetical order – is shown in Appendix 1.

In summary:

  • The optimist group has a 10 year return on capital trend (simple average) which rises at a rate of around 15 basis points per annum. The conservative group has a return on capital trend that rises at a rate of 40 basis points per annum.
  • The optimist group has a current return on capital of 8.8% while the conservative group has 11.1%
  • The optimists have seen an average of 9.1% EPS growth from 2002 to 2012 while the pessimists have an average EPS growth of 15.8%.
  • The optimists have a total shareholder return that is roughly 60% of the pessimist group.
  • In short, the optimists underperform on every relevant metric we can think of.
  • Additionally, the optimist group is not a more volatile group in terms of earnings – the optimist group contains companies from every sector except conglomerates. The conservative group contains all sectors except Conglomerates, Paper and E&C. Moreover, on a sector neutral basis we get essentially the same results
  • The optimist group spends marginally less as a percentage of revenue on both capital spending and R&D, so it is not necessarily about overspending.

This is a very important and very powerful conclusion as it suggest that aside from valuation, this may be the most important factor to consider when taking a medium to long term buy and hold decision. Once you have chosen the appropriate sector allocation, you then look for the company that is the most conservative in terms of historic growth expectation versus actual.

Appropriate Use Of Capital – Perhaps not as much of the story as we had thought.

Optimists expect capital projects to return more than those who are more conservative and so will invest in something at the margin that a others will not. We would hope that companies rank their capital uses by expected return, whether than is capital spending, R&D, share buyback, dividend. The optimists are placing more projects – capital and R&D – above the “return to shareholder” alternative than those who are more conservative.

In Exhibit 3 we show some of the data that supports this.

Optimist or Uncompetitive?

It is also possible that we have the terminology wrong. Maybe our optimists are not optimists at all, maybe they are simply not competitive, maybe its costs them more to build a facility than it costs a competitor. Maybe their operating costs are higher and consequently they fall short on the earnings and return on capital front not because of poor allocation of capital but because of poor execution or poor technology or an inefficient cost structure.


Exhibit 3

©2012, SSR LLC, 1055 Washington Blvd, Stamford, CT 06901. All rights reserved. The information contained in this report has been obtained from sources believed to be reliable, and its accuracy and completeness is not guaranteed. No representation or warranty, express or implied, is made as to the fairness, accuracy, completeness or correctness of the information and opinions contained herein.  The views and other information provided are subject to change without notice.  This report is issued without regard to the specific investment objectives, financial situation or particular needs of any specific recipient and is not construed as a solicitation or an offer to buy or sell any securities or related financial instruments. Past performance is not necessarily a guide to future results.

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