Guarding Against Optimists
In recent work we have found a very strong inverse correlation between the levels of optimism that companies project to the market (vis-a-vis their expected earnings and earnings growth) and the performance of companies (as measured by many metrics). Obviously, overpromising runs the risk that you will see serial negative earnings revisions and the potential to see your share price suffer as a consequence; but it happens. Roughly 20% of the companies in our 150+ Industrials and Basic Materials coverage group consistently over-estimate their earnings growth. This begs two very important questions:
- Why would you do it in the first place?
- Are there more consequences than negative revisions?
The “why” is complicated and is not the same in every case, but, it is important to note that it is not likely to be a deliberate act. Companies would not guide the street to a number that they know they cannot meet – at least not on a repeated basis. So it is reasonable to conclude that they buy into the earnings projections and are just as disappointed when they miss. We have a few suggestions as to the cause of overestimating:
- Some companies simply do not understand the dynamics in the business areas in which they operate and underestimate price erosion and commoditization
- Others employ permanently bullish planning assumptions.
- A bottoms up approach to budgeting where business heads are incented to be bullish, either because they want capital, or because they do not want to put themselves (or the businesses) at risk of exit/shut down.
- A top down directive – along the lines of “we need 10% growth, give me a business plan that shows 10% growth”.
- “Keeping up with the Joneses” – “If he can do 12% growth we must be able to also as we are in the same business”
Each company is likely different and a combination of what we have outlined above as well as other factors.
For companies that are overly optimistic, the consequences are severe; and the implications are not limited to simply a pattern of negative earnings revisions. These companies underperform their more conservative peers on every metric that we think is relevant, as the behavioral tendency to overestimate impacts other key management decisions especially those relating to capital allocations. The chart below compares an aggregate of the 20 most bullish in our universe with the 20 most conservative. Note that the optimistic group does not outspend the conservative group. This analysis works across sectors and within them. The optimistic group is no more volatile than the conservative group in terms of earnings, if anything the conservative group shows more volatility.