The Hindu Business Line : Weathering the quarterlies

A few analysts tend to make accurate forecasts of a company's earnings; a few miss them by a mile. The trouble begins when a wide range of such estimates are aggregated into a "consensus" view that falls between the two extremes.

KEENLY watched and widely disseminated, quarterly earnings announcements by companies are now important triggers for stock price behaviour. Stocks of companies that come up with "better-than-expected" numbers for a quarter are swiftly pegged up. Punishment is instant for a company that misses, even narrowly, the street expectations.

But, as an investor, how seriously should you take it if a company does not deliver to street expectations? And how much should you rely on the quarterly earnings to decide if you should raise or lower your exposure to a stock?

Where is the consensus?

To start with, it is not unusual for a company to report earnings that are way out of sync with the consensus analyst forecast. Steel major SAIL reported a 1 per cent profit growth this June quarter, even as a group of analysts polled by Bloomberg expected a 56-per cent jump.

Reliance Energy posted a 42-per cent increase in its profit, though analysts actually expected a drop in earnings. So are these numbers reason enough to dump the SAIL stock or accumulate Reliance Energy's? No. This is because the "consensus" view may not accurately capture what the best analysts think about a company's prospects.

A few analysts tend to make remarkably accurate forecasts of a company's earnings; a few miss them by a mile. For instance, one research house predicted that SAIL's profits for the quarter would rise by 52 per cent; another predicted flat profits. The trouble begins when a range of such estimates for a quarter are aggregated into a "consensus" view that falls somewhere between the extremes.

The method of arriving at the consensus may also differ. Bloomberg usually puts out the median forecast for the analysts it has polled; others use an arithmetic average. Such measures work well when there are minor disagreements among analysts on where a company is headed; they may be really off the mark when forecasts straddle two extremes.

In a scenario where analysts strongly disagree even on broad trends, such as where commodity prices are headed, or whether a economy will continue to grow at the same pace, forecasts for corporate earnings can be expected to diverge considerably.

A quarter at a time

Then, there is the question of whether the quarterly numbers are good enough indicators of where a company's earnings are headed over a one- or two-year period. Quarterly numbers are sometimes the only periodic indicator you have to check whether a company is on course to delivering the growth rates that you expect. This seems particularly important now, when stock prices seem to factor in years of earnings growth at a stretch.

However, before reacting to quarterly numbers, investors should keep in mind that few companies generate their earnings in an even stream over the four quarters of the year. The seasonal element tends to magnify earnings performance in specific quarters.

The April-June and January-March quarters are harvest time for companies that market agricultural inputs; October-March represents the peak crushing season for sugar companies; the monsoon months are supposed to be dull for cement makers; and September-January is high season for hoteliers. When evaluating results from these sectors, investors need to watch not only for expected seasonal bumps in earnings, but also for a possible break from the usual pattern. Fertiliser and agrochemical companies have reported an unusual drop in sales in this particular June quarter. If this is because of a delayed start to the monsoon, numbers could be better in the next quarter.

Cement companies have not reported a lull in their sales numbers this monsoon; could this mean that the acceleration in sales in the second half of the year will be lower than usual?

Then, there may be one-off events and accounting issues that can impact numbers for a specific quarter, but have no long-term implications for a company's earnings. After reporting unexpectedly strong earnings growth this June quarter, Dr Reddy's Labs has cautioned that the momentum may be difficult to sustain for the rest of the year, as revenues benefited from postponement of sales due to VAT.

Quarterly numbers can also be distorted by accounting policies. When a company makes its tax provision for the year, how it accounts for advertisement expenses and how it invoices its goods to dealers can all have a material impact on a quarter's performance; the effect of these numbers tend to even out at the end of the year.

Trends more important

All this clearly suggests that you cannot read too much into a company's earnings announcement for a single quarter. While a single quarter may not say much about a company's prospects, the trends indicated by successive quarterly performances can be quite important.

A steady deceleration in sales or revenue growth over consecutive quarters can be a sign of dwindling market share, slowdown in order flow or a ramp-down from clients. Fluctuating profit growth can be a sign that the company is unable to pass on volatility in input costs.

All this leads us to answers to some of the questions raised in the beginning:

Don't take it too seriously if a company misses street expectations for a quarter.

Dissect a quarter's performance to find out whether the trend is sustainable.

Pay more attention to the trend of revenue and profit growth over several quarters.

Crucial information that will help you decide whether to buy or sell a stock is usually available from a string of bad or good quarterly numbers, rather than just the latest one.

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