Earnings Season Busy-ness

Published on 01/24/20 | Saurav Sen | 2,480 Words

The BuyGist:

  • Every quarter, the meerkats come out in the markets. 
  • Overreactions to "earnings misses" and "earnings beats" are driven by the most anxious meerkats. 
  • The problem is short-termism. 
  • In this jungle, a long-term perspective is a massive competitive advantage. 
  • We give some pointers on avoiding the rat race. We know. We've been there.

The meerkats come out.

Four times a year, investors and traders go crazy while staring at their screens. And six times a year, they can barely breathe. Every quarter, companies report earnings and have earnings calls. And about 6 times a year, the Federal Reserve issues “minutes”, which are parsed through with the precision of a watchmaker. Reactions to both these periodic events are usually exaggerated.

It’s like a “Meerkat Effect” – the tendency to have an acute attention deficit while staring at the news/stock ticker. I know the feeling because I’ve been there. I was paid to be a meerkat, and issue immediate earnings “notes” so that my overlords could trade on them. It was ridiculous.

There are enough meerkats in the markets to make stock and bond prices swing wildly at the slights hint of an “earnings miss” or an “earnings beat”. Charts go crazy. CNBC goes nuts. It’s mayhem. The “earnings expectations” game is ludicrous. Stocks and Bonds are rewarded or penalized based on whether the underlying company met Wall Street expectations or not. I always found it funny that it’s the company that gets it wrong, never the Analyst(s). I mean, what the company does is a fact. What the analyst had “forecasted” is conjecture – based on elegantly complicated spreadsheets – but conjecture, nevertheless.

These overreactions shouldn’t be taken seriously, most of the time. That’s because, usually, the company doesn’t change all that much in a span of 3 months. It’s the same company that will have its ebbs and flows. The fundamentals – what we consider to be a company’s competitive advantage, the durability of that advantage and its management team – usually remain intact.

These overreactions are a slap in the face of “Efficient Market” fundamentalists. If a stock loses 10% of its market value based on 3 months of extra data in its 5, 10, 15-year existence, it’s hard to call the market “efficient”; well, not in the sense that these fundamentalists believe. They are convinced that the market is always right, and you can’t beat it because it’s a divine sort of collective wisdom that’s unbeatable. The giants of investing think this is rubbish. Maybe, Howard Marks puts it best (and most diplomatically):

"When I speak of [the efficient market] theory, I also use the word 'efficient' but I mean it in the sense of speedy, quick to incorporate information, not 'right'. I agree that because investors work hard to evaluate every new piece of information, asset prices immediately reflect the consensus view of the information's significance. I do not, however, believe the consensus view is necessarily correct.

If nothing else, remember this: the latest market price is set by the most anxious – optimistic or pessimistic – trader. Most investors in that particular stock or company are just sitting on their a**. Don’t be fooled into just “doing something” by the most hyper player of the game. Let him go nuts. You don’t have to.

The problem is short-termism.

Reactions are exaggerated because many investors and traders are short-term oriented. They think more in terms of stock/bond price, rather than the underlying company. If you do that, you’ll be thinking about the “popularity contest” – whether “others” will like the stock or not. None of the giants of investing behave like this.

If your time horizon is a few days or weeks or months, you’ll be more antsy. Every bit of news – an “earnings miss” by, say 1 cent per share – creates indigestion. Meerkats come out in full force. They react. And they compel you to react. Why? Because when your time horizon is short, volatility matters. If you’re thinking of exiting an investing in a few days or months, a 10% swing will make you nervous.

"Stock prices will always be far more volatile than cash-equivalent holdings. Over the long term, however, currency-denominated instruments are riskier investments – far riskier investments – than widely-diversified stock portfolios that are bought over time and that are owned in a manner invoking only token fees and commissions. That lesson has not customarily been taught in business schools, where volatility is almost universally used as a proxy for risk. Though this pedagogic assumption makes for easy teaching, it is dead wrong: Volatility is far from synonymous with risk. Popular formulas that equate the two terms lead students, investors and CEOs astray...If the investor, instead, fears price volatility, erroneously viewing it as a measure of risk, he may, ironically, end up doing some very risky things."

On the other hand, if you’re in it for the long-term, volatility hardly matters. If you’ve done your homework, you have a true north – an estimate of how much a company is worth. This estimate should be a range, not a scientifically precise number. If you have this range in mind, it’s easy to ignore the overreactions, especially during earnings season. In fact, at The Buylyst, we like “earnings misses”. It’s a weird form of schadenfreude, if you will, because we’re happy to pick up some more of a “comfortable company” at an even more “comfortable price”. Our long termism helps. We’re not looking to exit in a few weeks. We’re going to hold on, possibly for years.

But how long is “long-term”?

This is the million-dollar question in Investing and in Economics. Nobody knows. But it’s long enough for an investment thesis to play out. Usually, that’s at least a year. I can’t give you a precise number of months or years, but I implore you to be patient and not dogmatic about time-windows. Compounding is the 8th wonder of the world, only if you give it time. Patience is Buffett’s competitive advantage. It can be yours too. You just have to sit on your a**, as Munger would put it.

"If you invested Berkshire Hathaway-style, it would be hard to get paid as an investment manager as well as they're currently paid - because you'd be holding a block of Wal-Mart and a block of Coca-Cola and a block of something else. You'd be sitting on your ass. And the client would be getting rich. And, after a while, the client would think, "why am I paying this guy half-a-percent a year on my wonderful passive holdings?" So what makes sense for the investor is different from what makes sense for the manager. And, as usual in human affairs, what determines the behavior are incentives for the decision maker."

Here’s a rule of thumb that I use – it may offer you some comfort: I shoot for at least a 10% Annualized Return. What does that mean? Simply put, when I invest, I have 3 “hard” data points and 1 flimsy one:

  1. Fact: Current Price.
  2. Hard(ish) data point: My estimate of what the stock or bond is worth.
  3. Calculation: The difference between #2 and #1 is my estimate of upside.
  4. Flimsy data point: holding period.

If my upside is, say 30%, I do this quick math in my head: Am I prepared to hold it (wait) for 3 years? If so, I take the plunge. It’s borderline green light. Why borderline? Because the rough math indicates that my annualized return is 10% (actually it’s below 10% because of the it’s a geometric mean). If I’m not willing to wait 3 years, I shouldn’t bother. It’ll give me too much stress.

The mental math above is standard for us at The Buylyst. Our return goals are – in a nutshell – at least 10% a year over the long-term. When we make an investment, that’s our requirement.

If you’re curious about how this ties up with our standard discount rate of 5%, you’re opening a new can of worms. That’s fine. You can spend a few minutes reading this. But here’s the short answer: we intend on making most of our returns because we’re buying things at a discount. The 5% number is our opportunity cost of doing nothing. So, if we were to buy at NO DISCOUNT, we would be indifferent between “doing nothing” and buying this asset. What is doing nothing? Holding cash or buying a safe corporate bond that’s sure to pay us 5% (good luck finding that these days).

Back to our topic at hand. The best I can tell you is to be prepared to hold a stock for a couple of years. Then you can be quite indifferent to earnings reports, the meerkats, all that unnecessary volatility and the indigestion that comes with it. Save money on your Pepto-Bismol.

This is why we like “Sustainable” numbers.

I’m not referring to Sustainability here in terms of “Green Investing”, although we do plenty of that. I’m referring to a metric we use in our valuations called “Sustainable Free Cash Flow”. This is the heart of our valuation process. We take a look at how a company has been performing – how much free cash flow it has been generating. And then we dial that up or down depending on our views of the company’s fundamentals to arrive at a “sustainable” free cash flow estimate. What is “sustainable”? It’s a level we think is easily achievable by a company, give our view of the sport they’re playing (their thematic exposure), their competitive advantage in that sport, the durability of that competitive advantage, and the management team in place to ensure that all of the above stays intact.

We think of it as an “average” free cash flow number that we can stick into our discounted cash flow models, without having the need to minutely forecast every single year in the future. Those valuation models – with point-by-point, line-by-line, year-by-year “forecasts” – look professional and all that but we think it’s just busywork. It’s false precision, false comfort, and intellectual babble. We keep our valuation exercise simple, so we can focus more on the qualitative stuff.

A complicated valuation model never increases the chances of good returns. In fact, we think complexity in valuation and returns are probably negatively correlation. Complicated spreadsheet models also lead to more “meerkatism” because a small change in one variable tends to have a chain-reaction all the way to the estimate of “intrinsic value”, as if all this is a hard science. It’s not. And changes in the “fair price” cell in Excel causes anxious people to act. This is counterproductive.   

We think spending time and energy in connecting the dots – in reading, observing, thinking, scuttlebutting – that’s the stuff that increases our chances of generating good returns and handily beating any so-called “passive” strategy. Complicated Models don’t give more insights. They’re just a numerical representation of qualitative insights. It’s not that we ignore calculating numbers. We just spend more time arriving at the inputs. Then the calculation is easy.

Here are the key takeaways.

  1. We focus on the long-term.
  2. We spend most of our time and energy in making educated guesses about: 
    1. Is the company playing the right sport?
    2. Does the company have a competitive advantage in that sport?
    3. Is the competitive advantage durable?
    4. Does it have a good management team in place to play the orchestra?
  3. Then we spend some time estimating how much this company is worth.
  4. If the company is trading at a significant discount, we’re inclined to buy.
  5. When we make the buy decision, we’re prepared to be in it for 2-3 years.
  6. The quarterly swings in the meantime – because the company did or did not meet some overengineered “EPS estimate” – don’t bother us.
  7. We just keep calm and carry on.

Being patient in investing is a massive competitive advantage – much more so than being a genius. Here’s Buffett on the topic:

“How did you get here? How did you become richer than God?” Buffett took a deep breath and began: “How I got here is pretty simple in my case. It is not IQ, I’m sure you will be glad to hear. The big thing is rationality. I always look at IQ and talent as representing the horsepower of the motor, but that the output—the efficiency with which the motor works—depends on rationality. A lot of people start out with 400 horsepower motors but only get 100 horsepower of output. It’s way better to have a 200 horsepower motor and get it all into output. “So why do smart people do things that interfere with getting the output they’re entitled to?” Buffett continued. “It gets into the habits and character and temperament, and behaving in a rational manner. Not getting in your own way. As I have said, everybody here has the ability absolutely to do anything I do and much beyond. Some of you will, and some of you won’t. For those who won’t, it will be because you get in your own way, not because the world doesn’t allow you.”

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