Shock and awe works, but should it?

Imagine you are an investor, and you are convinced one of the stocks in your portfolios is going to grow strongly. Then, the company beats earnings estimates at the next results season but it also revises its growth outlook downward. It’s easy to dismiss this weaker growth outlook in the light of current strength in the business and you might be tempted to hold on to the stock.

Alternatively, imagine your outlook for another stock is rather pessimistic, but at the next results presentation, the company presents shock and awe results that blow away all the estimates of professional equity analysts. If the results are strong enough, you might well be tempted to change your view of the company and even buy some of its shares given the strong results.

I am oversimplifying things here, but this is what I see happening so often in markets, particularly during results season. Companies can present blowout results that will not only make the stock leap but also change the consensus expectations about the future prospects of the company amongst investors. But is a blowout quarter or even a blowout year predictive of future success?

Meanwhile, companies can manage to beat expectations quarter after quarter and keep their share price aloft while at the same time quietly chipping away at their long-term growth prospects until, of course, one day, they can’t beat earnings expectations anymore and the disappointment amongst investors will tank the stock.

The job of equity analysts, fund managers, and investors, in general, is to analyse corporate results for signals about the future prospects of the company. The problem, however, is that a signal has two components, reliability and strength. A signal can be a reliable predictor of the future but have very low strength like the company’s assessment of long-term future growth prospects. Or it can have large strength but be an unreliable predictor of future results like shock and awe earnings growth in the past quarter.

Of course, we all would love to have signals that are both strong and highly reliable but in the real world that rarely happens. Instead, we investors have to sift through a variety of signals both strong and weak, and focus on the ones that are relevant while ignoring the ones that are not.

Unfortunately, it seems we are doing a lousy job at that. José Astaiza-Gómez has looked at the earnings estimates and buy recommendations of equity analysts and the revisions to these estimates and recommendations. He found that analysts tend to ignore evidence that contradicts their previously held belief about a stock until the signal strength becomes very large (he found a tipping point somewhere around the top 20% in signal strength). Then they revise their opinions and estimates. So, analysts react to signal strength and tend to revise only once the signal has crossed a certain threshold. But do they react to all signals or p0nly the ones that have some reliability in forecasting the future? Unfortunately, he found no evidence that analysts take the reliability of the signal into account when reacting to a signal or revising their forecasts. They are reacting to signal strength but not to signal reliability.

And that is a problem because that opens the possibility of company management manipulating the share price with shock and awe results and the market becoming inefficient because reliable but weak signals are not incorporated ion the share price. Hence, investors who are able to identify signals that have high reliability even if their strength is low can earn superior returns.