In our view, small cap investors are short-term focused - they look to the next earnings report to dictate their buy and sell decisions. We believe investors’ primary focus should be on a company’s medium-term earnings delivery given it’s the significant driver of share price performance.
Based on AMP Capital and FactSet data, investing purely on the basis of consensus earnings forecasts has underperformed as an investment strategy and investors who undertake detailed fundamental bottom-up research can exploit this inefficiency.
While valuation is an important input, it is likely to be dominated by any adverse earnings effects, and its mean reverting nature makes it harder to predict. An earnings-based approach is resilient to valuation changes and its serially correlated nature makes it more predictable.
Investors should also understand a company’s positioning in the earnings cycle which is important in determining the price paid for that future earnings stream. As we outline below, earnings are the most important driver of returns and should be at the centre of any investment approach.
This is consistent with AMP Capital’s Australian small cap team's investment approach and its long standing “earnings drive share prices” philosophy.
Earnings delivery drives share price performance
The current price of any security should reflect the market’s future earnings expectations, but a company’s actual earnings delivery will ultimately drive its medium-term share price performance.
This has been clearly evident in the Australian small cap market. Assuming perfect foresight in being able to forecast earnings, companies that deliver strong actual medium-term earnings have demonstrated a track record of significant outperformance. Relying on consensus expected earnings growth forecasts, however, has consistently delivered below market returns. This is demonstrated in Chart 1 with ‘Actual Earnings Delivery’ representing perfect earnings foresight, and ‘Consensus Expected Earnings’ relying on consensus estimates.
The market is typically inefficient in accurately pricing new information that impacts earnings. Investors who carry out detailed fundamental bottom-up research and have extensive corporate access can better understand a company’s earnings drivers and therefore exploit the inefficiencies that arise as consensus estimates typically prove to be incorrect.
We believe those inefficiencies are set to increase. Based on AMP Capital and FactSet data, the Australian small cap market has seen an exodus of sell-side analysts, with a 20% decline in the total number of company earnings estimates available for Australian small caps since 2014. In our view, this is likely to be a structural change that will handicap quantitative strategies which rely on sell-side forecasts and provides further upside potential to investors that employ a fundamental research approach.
The importance of the earnings cycle and the price paid for future earnings
An understanding of a company’s positioning in the earnings cycle, in addition to the magnitude of earnings delivery, is also important in determining the price paid for the future earnings stream. Chart 3 outlines the typical company earnings cycle.
Companies exhibiting “improving fundamentals” are typically characterised by positive price momentum and stabilisation/improvement in earnings-per-share (EPS) revisions as a stock exits the downgrade cycle.
Stocks in the “upgrade cycle” are typically delivering price momentum and continued positive EPS surprise. A company with rapidly growing earnings can perform strongly despite seemingly high valuations.
We believe consensus earnings forecasts, however, eventually “catch-up” and become inflated which increases the future earnings risk. The key risk with using an earnings-based investment approach is when investors fail to recognise the end of the upgrade cycle, at the time where “growth underperforms”.
Counter-intuitively, at the start of the “growth underperforms” segment of the cycle we have seen investors are willing to pay a higher valuation multiple for a company’s future earnings than they were at the beginning of the upgrade cycle. In our view, these overvalued company’s typically disappoint on earnings delivery, and significantly underperform as earnings downgrades are compounded by valuation compression.By incorporating a valuation and sell discipline framework a strong signal to exit a position can be identified before negative earnings surprise or earnings deteriorate.
Indiscriminately selecting stocks based purely on a low valuation multiple is characterised by heightened volatility given “value traps” may emerge. These companies optically look very cheap but continue to further downgrade earnings and underperform the market. In our view, stocks with high multiples typically underperform given the risks around missing lofty market earnings expectations. Both strategies have a demonstrated history of underperformance in the Australian small cap market.
Valuation is an important input but is likely to be dominated by any adverse earnings effects. Combining value and momentum (including both price and earnings revision) factors delivers superior returns and diversification benefits for small cap investors.
We believe outperformance can be achieved across the entire valuation spectrum so long as investors avoid companies which disappoint on short-term earnings expectations. In our view, investors shouldn’t be afraid to buy/hold high growth stocks trading at premium valuations provided there is a confidence that earnings won’t disappoint. In our view, these companies typically deliver more than enough growth to justify their valuations.
In summary, an earnings-based approach is resilient to valuation changes and its serially correlated nature makes it more predictable. While valuation is an important input, this is likely to be dominated by any adverse earnings effects, and its mean reverting nature makes it harder to time.
We believe investors should minimise exposure to companies that downgrade short-term earnings
Many investors attempt to time their entry into stocks when they believe the last earnings
downgrade has been factored into the company’s share price, commonly known as “picking the bottom”. But we think such a strategy is fraught with danger given the serially correlated nature of earnings.
A positive (negative) company earnings announcement is more likely to be followed by a period of sustained positive (negative) earnings surprises driving share price out (under)-performance. The anomaly of earnings surprise being serially correlated and having explanatory power for future returns is well supported by academic papers.
Behavioural finance provides an explanation for earnings revision cycles. It identifies analysts’ tendency to “anchor” on their current forecasts and only change their forecasts gradually. In an environment where earnings cycles tend to be gradual and longer than many forecasting horizons, this suggests analysts tend to make a series of smaller changes to their forecasts, or ongoing revisions in a similar direction.
Earnings trends last longer than expected and earnings are serially correlated, so it usually doesn’t pay to try to pick turning points. Framing new information in the context of past events, and asymmetric reward structures by sell-side analysts that lead to conservatism in forecasting future earnings, also exacerbates the earnings revision cycle.
This performance anomaly is clearly evident in the Australian market with the signal being stronger for small caps relative to large caps and the serial correlation for earnings surprise (or at least the rewards following past surprise) stronger to the downside. Based on AMP Capital analysis, Australian small cap companies that downgraded short term earnings from 2000 to 2019 significantly underperformed the market, downgrading on average 3.1 times with an average duration of 9 months over the downgrade cycle.
The risk of being caught out by subsequent earnings downgrades or, even worse, “value traps” can be mitigated by using both price momentum and earnings revision signals to help select companies with valuation upside that have an improving outlook..
In conclusion
We believe investors should primarily focus on a company’s delivery of actual earnings, given this is the main driver of share price performance. An earnings-based approach may be resilient to valuation changes and its serially correlated nature makes it more predictable. An understanding of a company’s position in the earnings cycle is important in determining the price paid for that future earnings stream, and while valuation is an important input, adverse earnings effects are likely to dominate it. In addition, valuation is also harder to predict because of its mean reverting nature.
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