“All the money is made between the lines”

Understanding Q1 earnings, the framing bias and network effects.

Wall Street analysts, paired with the management of big listed firms, often adopt an “under-promise and over-delivery” strategy when it comes to quarterly earnings releases. If earnings forecasts where truly well informed, one would expect on average forecasts to line up with posted results and there to be just as many outperforming firms as there are underperforming firms. We would expect the errors in forecasting to be approximately normally distributed with mean zero. However, data does not support this claim. As counter intuitive as the following statement may seem, earnings results do consistently outperform expectations.

A slight understatement of expected revenue growth or EPS allows management to take advantage of the “Framing bias”. This is where what investors perceive or act on is influenced by the method of information delivery; or how the information is framed. The image below shows just powerful the framing bias can be… which yogurt would you be more likely to eat on a diet?

If revenues of a firm fell 3% compared to last year this should negatively affect the share price. Lower revenues lead to lower net income figures for the same margins, and ultimately, less cash returned to shareholders. However, what if analysts had forecasted a 5% decline in revenues? If the efficient market hypothesis is true, on the news that the top line fell less than expected the future fortune of the firm is actually rosier than the current share price might imply. By framing the earnings versus expectations rather than previous years, stocks can rally on negative “absolute” but positive “relative” news.

This quarter has seen such phenomena.

Technology stocks make up a large part of the major US indexes with titans such as Microsoft, Apple and Facebook having market capitalisation’s nearing ( in some cases greater than) the trillion dollar mark. Technology stocks are valued in a slightly more obscure way than other companies, with a large part of the valuation coming from the perceived “network effect”. Network effects are similar in nature to economies of scale. That is to say, bigger is better. Take Facebook for example. The more users on the platform, the more attractive the platform becomes for new users. Technology firms often need to hit an active user figure which is quite high to be profitable, but because software has low marginal costs profits going forward are extremely attractive. Unlike say a Yoga studio, the difference in cost between serving 100 clients and 1000 clients is minimal. Mark Zuckerberg understands this concept more than probably anyone else and in the early days of Facebook would finish team meetings with an instruction to “dominate”. He understood the importance of achieving a minimum critical scale and pursued it relentlessly. The Facebook eco system, which comprises Facebook, Instagram , Whatsapp and messenger, now has well over 2 billion monthly users.

This quarter Facebook beat revenue forecasts and met user number metrics forecasts and rallied as a result. This narrative is true for a large number of US mega caps. Revenues, earnings and margins have come in ahead of expectations and this positive surprise has pushed the S&P 500 to new all-time highs. Analysis out from Factset shows the percentage of companies reporting actual EPS above estimates (77%) is above the five-year average. However, ten out of the eleven sectors have reported a year-over-year decline in net profit margins, primarily driven by higher labour and raw materials costs. In the UK, we have seen a similar story. EPS targets have been revised down providing greater scope for an earnings outperformance. Unilever outperformed revenue expectations while Barclays had a mixed quarter with income coming in 3% below consensus.

To quote Efraim Diveroli from the 2016 film War Dogs, “All the money is made between the lines”.

In a similar fashion, we believe the true value one receives from studying annual reports is not the headline figures, but it is the management commentary on topics such as costs, consumer behaviour and industry trends; the real value is located between the lines. In particular, discussion of increased labour costs is something we are tracking carefully as a potential inflation tailwind. In previous commentary we noted that with valuations still moderate earnings outperformance has the potential to push equity markets higher. This has played out, but we still remain cautious given continued geo-political tensions, valuations turning from moderate to slightly expensive ( above the 5 year and 10 year averages) and the possibility of a renewed hawkish Fed if inflation picks up late cycle.

Daniel Gorringe, Investment Analyst