Monday, 28 May 2018

Analyst earnings estimates: Do they reflect reality?

“We don’t own it for the next quarter. It’s incredible to me how you read the investor conference calls… you read all the analyst reports… they talk about what it’s going to do next year. No one buys a farm based on whether they think it’s going to rain next year or not.”  Warren Buffet
Biased by career risk
In the analyst and fund management community (institutional side) there is a sharp focus on near-term performance. It is abundantly evident to these individuals that short-term underperformance could get them fired or at least reduce their take-home package.  

As a result, almost all earnings calls, television interviews etc. focus on the short-term triggers in the next one or two years. Therefore, their widely shared conclusions on growth, earnings etc. fails to focus adequately on the business ecosystem and competitive edges that generate superior performance in companies.

There is nothing inherently wrong with trying to focus on short-term catalysts in hopes of increasing the turnover of your capital. It’s just that I think this is an extremely competitive and crowded approach, which makes it very tough to use profitably. We at Zara prefer focusing on a business cycle of 5 to 7 years where there are a minimal number of players to trade/bring efficiency into the markets and where an understanding of a business and its valuations lead to superior performance.

Consensus earnings forecast versus actuals

Given below are consensus earnings estimates in the first quarter for various fiscals based on media reports in those years versus actual earnings in those years.



Earnings
Growth

No of yrs
Financial Year
Estimate in Q1
Actuals
Estimates
Actual
Difference
11
FY19
2000

25.2%


10
FY18
1980
1598 E
37.8%
11.2%
26.6%
9
FY17
2140
1437
48.0%
-0.6%
48.6%
8
FY16
1780
1445
10.7%
-10.1%
20.8%
7
FY15
1665
1608
24.1%
19.8%
4.2%
6
FY14
1470
1342
20.2%
9.7%
10.5%
5
FY13
1475
1223
37.2%
13.8%
23.4%
4
FY12
1265
1075
25.3%
6.5%
18.8%
3
FY11
1000
1009
10.8%
11.8%
-1.1%
2
FY10
850
903
8.8%
15.6%
-6.7%
1
FY09
1011
781
18.4%
-8.6%
26.9%
0
FY08
839
854
18.8%



Average



6.9%
17.2%


You will observe the following from the above data

·       On an average, the consensus estimate of earnings growth tends to be 2x or double plus of actual growth. Estimates of the increase in earnings were lower than actuals only in two years in a  decade, indicating that the errors in growth estimates are intentionally biased upwards. Otherwise, you would have to conclude that these highly intelligent workers have no clue of what they are doing.
·      You would note that post fiscal year ending March 2008; the estimates couldn’t predict the recovery timing nor its strength.
·    The extreme upwards bias in estimates in recent fiscals FY17 and FY18 reflects in addition to the usual forecast errors inability of the analyst to get their head around NPA write-offs in the banking sector.


Conclusions

In most cases, if you examine the incentive of the person you are dealing with, you can predict the extent to which you can depend on them if at all. When buying equities from a person incentivised to sell them to you like brokers, mutual fund distributors or mutual funds themselves, should n’t you expect them to hard sell eps estimates and talk only of forward pe, especially when actuals arent good enough.

“Forecasts may tell you a great deal about the forecaster; they tell you nothing about the future.” Warren Buffet

In marketing, some of these intermediaries will use forward earnings multiple of the market and compare it with the several years average trailing price to earnings,   when they should use the same period average of forward price to earnings multiples versus the current forward earnings multiple to have a meaningful comparison.

With the support of the upward bias of consensus estimates (not a prime mover though), markets in recent years have grown faster price wise than fundamentals like earnings and book value. Hence, it’s not fundamentals that have been the primary driver of the current market rally, but overseas developments namely the continuation of an easy money policy by the American federal reserve. After all, we in India measure our currency value with a loose peg to the dollar (the default reserve currency of the world). It’s a widely known fact that if you peg your currency value loosely or otherwise to another currency, you inadvertently import its monetary policy. No wonder we have seen loose financial conditions in India exactly when the US has had such conditions too. It also explains the correlated train wreck in the world markets in the years 1996, 2001 and 2009, and the peaks in 1994,2000 and 2007.

“Apply logic to help avoid fooling yourself. Charlie [Munger] will not accept anything I say just because I say it, although most of the world will.” Warren Buffett

As a panacea for these issues, I recommend cultivating independent thinking,  patience and maintaining a long investment time horizon. If then you find the rare opportunities from market mispricing’s, you may allocate capital aggressively. Otherwise, you should sit patiently on the sidelines, which is generally most of the time.

                                       
In your service

Dinesh da Costa, CFA                                                                          28th May 2018
Principal Officer & Investment adviser
Zara Investment Advisory
Email:dineshd@zarainvestmentadvisory.in
Phone:(0832)2268252,Mobile: 9822280576
Delivering on an "Investment edge through risk management."


Please leave your comments below or email at dineshd@zarainvestmentadvisory.in 

This blog expresses the views of the author as on date and such views are subject to change without notice. Zara Investment Advisory/Dinesh da Costa (used interchangeably) has no duty or obligation to update the information contained herein. There is no representation made. Moreover, wherever there is a possibility of gain there is also a possibility of loss.

The blog is being made available for educational purposes only and should not be used for any other purpose. The information contained herein does not constitute and should not be construed as an offering of advisory services. Certain information contained herein concerning economic trends and performance is based on third party sources, believed by Zara Investment Advisory to be reliable. However, we cannot guarantee the accuracy of such information and have not independently verified the accuracy or completeness of such information or assumptions on which such information is based.


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