Jump Into Earnings With Your Eyes Open

"Sandbagging" is a practice that makes management teams and analysts look good

   

As we jump into another earnings season, it’s important to do so with our eyes wide open. Some stocks move dramatically after their earnings announcements, while some stocks barely move at all. Some companies seem to hit their earnings expectations on the nose quarter after quarter, while other companies seem to miss the mark — to the upside or to the downside — time and time again.

So what’s really going on? To understand what goes on during earnings season, you need to understand a few tricks of the trade, and the market participants who utilize these tricks.

Let’s start by looking at the key players in the market at earnings season.

The Key Players

When it comes to earnings season, these four key players tend to dominate the investing landscape:

  • Corporate management teams
  • Sell-side analysts
  • Buy-side analysts
  • Fund managers

Corporate management teams are not only responsible for the day-to-day operations of their respective companies, but also for disseminating information regarding both the company’s past performance, and the team’s expectations for future performance. These teams distribute this information via corporate filings with the SEC — the most common are the 10-Q (quarterly report), the 10-K (annual report) and the 8-K (interim report released as needed if material information needs to be disclosed between quarterly reports) — through earnings conference calls, and through various other investor meetings. Of course, not all management teams provide forward-looking guidance, but most do, and it plays an integral role in setting expectations.

Sell-side analysts work for market-research firms. These analysts follow a number of stocks (typically within a particular industry group), produce research reports on those stocks and then sell those reports to investment firms. In other words, they don’t actually make investment decisions. They simply provide insights and their opinions to those who do make investment decisions. This means they don’t have any monetary skin in the game, but they do have reputational skin in the game. If a sell-side analyst consistently provides inaccurate information, investors will stop paying for his research.

Buy-side analysts work for fund managers. These analysts identify potential trading opportunities, compile a compelling investment case, pitch the trade to the fund managers and then track the stock once it is officially part of the fund’s portfolio. In other words, they have a direct impact on investing decisions. This means they do have monetary skin in the game because their compensation is often partially based on fund performance. If a buy-side analyst consistently provides inaccurate information, he gets fired.

Fund managers are the people who actually make the buying and selling decisions. They drive the markets.

Now that you know who the key players are, let’s take a look at one of the oldest tricks of the trade: “sandbagging.”

Sandbagging

Sandbagging is the practice of downplaying what you think the actual performance of a company, or stock, is going to be in the future. For instance, if you believe a company might announce earnings per share (EPS) of $0.20, you might sandbag your estimate and tell everyone you believe the company is going to announce EPS of $0.17.

The term “sandbagging” doesn’t have anything to do with the large bags filled with sand that line the street in order to protect your home from flooding. Rather, it is derived from a deceptively dangerous makeshift weapon comprised of a bag, or a sock, filled with sand. On the outside, this weapon looks like it would be quite harmless. After all, bags and sand are both relatively soft. However, when you cram a handful of sand in the corner of a bag, or the end of a sock, and then swing it at someone, it actually generates a great deal of force and can cause a surprising amount of damage.

Corporate management teams and sell-side analysts are often guilty of sandbagging. But why? What purpose does it serve?

Corporate management teams will sandbag their forward-looking estimates because it makes them look better when the company is able to beat estimates in its quarterly earnings report. It’s an ego thing. It allows them to tell Wall Street that they are such effective managers that they were able to exceed even their own expectations. The management team at Apple (AAPL) was notorious for sandbagging their estimates during the run up in AAPL’s stock price.

Sell-side analysts sandbag their estimates because clients who buy their research — especially those who are buying and holding stocks — are much more forgiving of an estimate that comes in below, rather than above, the actual number. After all, isn’t it better to be pleasantly surprised with better-than-expected news?

7 11 13 aa 300x183 Jump Into Earnings With Your Eyes Open
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You can see an example of significant sandbagging in the sell-side estimates for Alcoa‘s (AA) earnings performance in the chart.

Notice how the estimates for each year start out optimistically high, but as time goes on, analysts revise their estimates lower and lower. As more information about the condition of the company and the state of the general economy becomes available, analysts are able to provide more accurate forecasts — but they still want to come in below, or just at, the actual numbers.

Case in point: AA beat analyst expectations on Monday when it announced EPS of $0.07, compared to the consensus estimate of $0.06. But it was only able to beat expectations because expectations had dropped from $0.16 per share in early-April.

InvestorPlace advisors John Jagerson and S. Wade Hansen are co-founders of LearningMarkets.com, as well as the co-editors of SlingShot Trader, a trading service designed to help you make options profits by trading the news.  Get in on the next trade and get 1 free month today by clicking here.

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