Equity Recap

---

If you have been closely following the Q3 earnings season you may have noticed something interesting going on between certain earnings announcements and their stock prices. Some companies reported disappointing quarterly earnings and their stock price suffered for it, while others reported surprise results and saw their prices increase. Still others reported earnings that surpassed estimates, yet their stock price suffered. But wait, how does that happen? Allow me to introduce you to what’s known as the Earnings Game (the following ideas and principles are credited to authors Eccles, Herz, Keegan, and Phillips, as published in The Value Reporting Revolution).

CVS stock price at time of Q3 earnings, .66 actual vs .64 expected

The Game as it should be

Rule 1: Companies should report their earnings the way they are. This entails that managers simply do the best job they can within morally sound and effective business practices. This means no attempts to skew earnings results to meet the market’s expectation.

Rule 2: Analysts should merely interpret earnings, not speculate what they will be. They should interpret a bigger picture and focus on the business’ long term financial outlook.

Rule 3: Investors should consider the analysts’ outlook and then formulate and act on their own position.

The Game as played on the Street

Rule 1: Deliver a track record of consistent earnings growth. Most companies have strong metrics of internal reporting as well as financial ones. Quarterly earnings are a sign of how well management is doing in implementing these measures and reducing the amount of uncertainty. This may include trade-offs of long tem performance for short-term results.

Rule 2: Manage earnings expectations carefully. It is the job of the analysts to set the earnings expectations for the quarter. Yet they do this with a great amount of help from a corporation’s management, with upwards of 80% of large-cap companies reviewing analysts’ estimations. It’s a good trade for some; the analysts look smart for projecting the right numbers, while management gets to set their own expectations.

Rule 3: Slightly beat earnings expectations. So increasingly analysts and managers are working together to set earnings expectations. Not surprisingly earnings are increasingly beating expectations by a slight amount. In 1992 about 50% of companies beat expectations while 50% disappointed, while in 1999 upwards of 70% of companies beat estimates.

Rule 4: Make business decisions to meet or beat expectations. Since management has a good idea of what is expected they can better game plan for it. This can often be beneficial, ensuring management will work hard to meet these goals. This could also possibly lead to questionable business practices (i.e. delaying PPE maintenance or marking down merchandise to increase sales) and accounting trickery.

Rule 5: Hammer stocks that fail to meet expectations. Companies that fail to meet expectations have their stock prices punished for doing so, which is fair enough. The down side of this is that it further increases the incentives for management to do everything possible to meet earnings expectations, often by questionable means. One must simply look at the cases of HBO Company and Enron to see that is always not a good thing.

Rule 6: Listen carefully for the Whisper Number. Since the Street knows that analysts and managers have set an earnings estimate that is artificial, they derive no real value from the quarterly reports. Being the intelligent and creative people they are, they have created the Whisper Number. The Whisper Number is the actual, yet un-official, expected earnings number by the Street. These Whisper Numbers are usually reserved for large pension funds, hedge funds, and investment banks. The analysts working for investment banks want to both curry favor with large clients and increase firm wealth, all at the expense of the individual investor. Whisper Numbers are usually higher than the expected earnings numbers.

Rule 7: Hammer Stocks that fail to meet the Whisper Number. This is the reason for seeing companies surpass their earnings estimate and still have their stock price decrease. Studies show that when quarterly earnings fail to meet their Whisper Number, in a five-day span the stock price decreases 70% of the time.

So what is the answer to solving and beating the Earnings Game? Some suggest that by knowing the Earnings Game and knowing the Whisper Number the individual can now stand on equal ground as the Street. Some websites are available that provide quite good Whisper Numbers for a price; EarningsWhispers.com and WhisperNumber.com. Still others contend that the Earnings Game is a no-win proposition. Once the Whisper Number is more widely known its effectiveness is diminished. And since the Whisper Number has originated from the Street they have since moved on to more secretive metawhispers and other games. That may possibly be the case but still it is important for individual investors to know about the Earnings Game and to avoid its trap.