Public overreaction to Revenue and Earnings Companies survive and thrive based on investors’ confidence. This confidence is built on companies’ ability to meet their earnings and revenue targets consistently. Acceptable targets are those that grow regularly inline with the industry of the respective company. Since the business world is very competitive, survival of any company is guaranteed only when it can grow at the average rate of its competitors. Failure to do so will shrink its market share, its ability to compete and consequently squeezes it out of the market. Obviously the growth has to be profitable, although an exceptional one or two non-profitable quarters might be tolerated.
Under normal conditions, a company has to grow both its revenue and earnings. The increase in earnings is driven by two components namely, growth in revenue and increase in operating efficiency — profitability. Revenue increase has a stronger long-term effect on earnings, since efficiency improvement can be increased up to a certain level. Companies’ performance is monitored relative to their historical results and to their competitors’ performance. A leading company has to improve its performance regularly in order to beat the average of its industry. Accordingly, companies and markets set objectives, based on the above parameters. These objectives become “sacred” expectations by the stock market community. Companies loose their creditability whenever they fail to meet the market expectations. This loss in investor confidence is usually translated in a reduction of their respective share price. The opposite is true when a company meets or exceeds the market expectations targets. Meeting the objectives gradually leads to investor confidence. Although meeting the planned targets is very important, however short term market reaction to the results is not consistent since it is overwhelmed by investors’ sentiment.
The winners are companies that can demonstrate consistent earning and revenue growth. This consistency increases the confidence in such companies and accordingly their share price. Funds managers invest substantial resources trying to identify the potential winners. The manager of Dodge & Cox Stock Fund for example likes companies that have low earnings expectations and believe that such companies lead to positive earnings surprises in the short term. He claims that the stocks of such companies have a limited downside risk, since their price weakness have already been discounted by the market.
Public Overreaction: People are normally divided into various groups or categories. There are few leaders in each group or category, while the rest follow them. The classification and behavior of the investors group is not different. Although many investors claim to be leaders, the fact is that they are frequently swayed by other people’s actions. If someone thinks an investment in a certain company is good, many people quickly adapt the same thinking. Accordingly if an investor buys a particular stock, other investors follow. And if he sells, they do the same. Depending on how quickly they follow, investors might buy the same stock at a higher price relative to the “leader”, sell it at a lower price or don’t sell it at all because they did not know when their leader sold his. This approach leads to a loss or at best to a profit lower in percentage terms than the profit of the investor that they followed.
Mass psychology causes bandwagon effects of over-reaction. News that people are buying particular stocks spreads quickly, which increases the demand on such shares and consequently its price. Due to increased demand, the price may reach a high unjustifiable level, much higher than its intrinsic value. In other words it makes it almost impossible for such a company to protect the high share price with performance, i.e. respective increase in earnings. Anyone who buys the stock, even if it is of a very good company, at a price above its intrinsic value, will have to wait for a long time before she starts to make a profit.
A similar situation happens when the news about selling a particular stock spreads. People start dumping such stocks thus lowering the share price dramatically, to below its intrinsic value. Research has established that the effect of public overreaction is much bigger than the real news that initiated it. However, with time the share price settles back to around what it was before the news, and in the long term to its intrinsic value. Public overreaction happens regularly, and it creates an opportunity for the smart investor to make money over a short period.
Financial performance news is measurable. A company may beat its profit target by say 10%, however, public reaction to the same or identical news is not similar. The reaction may vary wildly from one situation to another. Sometimes the reaction is hardly noticeable, at other times it is excessive. But the fact remains that the reaction is unpredictable. An overreaction by investors creates a new perceived value of a particular share. The difference between real and perceived value of a stock, is an opportunity which can be turned into profit.
(Salim J Ghalayini, [email protected], is the author of “Stocks for the Practical Investor”. He manages several investment accounts.)