The Downside of Earnings Reports

 | Oct 17, 2011 | 1:30 PM EDT
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Well, it's not the Yankees vs. Phillies match the television executives (and I) wanted to see, but Texas is a decent market and the Cardinals have a fiercely loyal fan base that will be glued to TVs, watching the fall classic. A Tigers vs. Brewers series would have prompted cool story lines, but not much of a TV audience. As baseball season is winding down for the year, another season is ramping up. Investors and traders are now in the thick of earnings season as the majority of publicly traded companies release their earnings estimates over the next few weeks.

Citigroup (C) and Wells Fargo (WFC) released their quarterly numbers earlier today, and I will thoroughly review these earnings releases later. But, I already see in the Citi report that revenues are pumped up by a $1.9 billion credit valuation allowance (CVA). JP Morgan (JPM) had a large debit valuation allowance (DVA) in its report last week that aided its bottom line. Citi also released $1.4 billion of loan loss reserves back into the income statement. As a result, Citi's stock is up this morning since the bank beat analysts' estimates. Wells Fargo cited a loan loss release of $800 million in its report, but, at first glance, I do not see a CVA or DVA in its income statement.

In early trading, investors are reacting to the reports in typical and predictable fashion. Citi shares are up a bit more than 2%, increasing the market cap by about $1.7 billion. Wells Fargo is down in value by roughly $2 billion. This type of reaction from trades is absolutely ridiculous. The value of neither bank changed overnight by anything close to those numbers. The short-term change in Citi, particularly, is just silly. When you back out the CVA and reserve release, revenues were down across just about all lines of the business. Credit losses improved, but they are still high on a historical basis.

Business is a marathon not a sprint. A three-month period does not tell us much about a business, its operating conditions or its trends. Yet, literally hundreds of billions of dollars are wagered in the stock market based on assumptions of quarterly results. Corporate executives shoulder huge pressure to make the numbers each and every quarter. Bonuses are based on exceeding three-month earnings and revenue targets. Inevitably, this leads to managing the numbers -- not the business.

In a 2005 article in The Financial Analysts Journal, Professor Alfred Rappaport of Northwestern University pointed out in survey results that 80% of CEOs who were interviewed admitted to delaying projects, research and development expenses or hiring if doing so would allow them to hit their quarterly estimate. Stock buybacks and earnings accruals are a few other tactics mangers can use to hit the all-important, quarterly number. It seems that more attention is paid to increasing the value of the shares for day traders and swing traders at the expense of long-term shareholders in today's capital market casinos.

Over the next few weeks, hundreds of billions of shareholder value will rise and fall based on three-month results. I do not want to diminish the importance of quarterly reports; they are needed to keep investors reliably informed as to changes in the condition of a company, and they allow investors to gain information about trends in the business and the financial condition of a company. However, one quarter in itself does not offer much about the overall picture for any one company. Every minute that company executives spend giving Wall Street an estimate of business results for the next three months is a waste of time and uses energy that should have been spent improving the company.

The focus on short-term results is a severe handicap for business. Far too many traders and too few investors make up the market. The ultimate value of a company is how much free cash flow it produces over time, or the asset value built over time. The plus for long-term investors is that often traders will drive the price of a good company far below the actual value of the company, which allows us an opportunity.


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