How to manage investor reactions to earnings estimates

Trying to guide the market with early disclosures can be tricky

It's human nature to take the credit when things go well and blame something or someone else when they go badly.

Some companies do the same thing – taking the credit for good profits but blaming an outside factor such as the weather or the economy when earnings aren't as strong as investors had hoped.

Recent research led by Wei Chen, a senior lecturer at UNSW Business School, suggests that investors react differently to a negative earnings surprise, depending on whether the company attributes the variation to internal or external factors.

In their paper, Investor Reactions to Management Earnings Guidance Attributions: The Effects of News Valence, Attribution Locus and Outcome Controllability, Chen and her colleagues Jun Han and Hun-Tong Tan looked at how investors reacted to companies' earnings guidance and the reasons they supplied for any variation.

Companies that are listed on the share market usually provide investors with updates on how much money they are likely to earn in the current or coming quarter or year.

Known as guidance, these earnings estimates affect investor perception of the company and the stock price, depending on whether they were higher or lower than the profits investors were previously expecting the company to earn.

Companies can also provide a reason for the good news or the bad news and these can be internal, such as a successful marketing campaign or cost savings not being delivered, or external, such as a cold summer reducing swimwear sales or aggressive discounting by a competitor. 

'If there is negative news, companies usually attribute it to a bad economic environment or some external factor, but we find that the investors' reaction is actually opposite to the intention of the managers'

WEI CHEN

Shielding blame

The researchers suggest that "by providing external/internal attributions for negative/positive news guidance, managers aim to temper investors' negative reactions to bad news and strengthen investors' positive reactions to good news".

However, Chen says that when companies try to manage investor reaction and shield themselves from blame for a poorer than expected performance by blaming external factors, it can often backfire.

"If there is negative news, companies usually attribute it to a bad economic environment or some external factor, but we find that the investors' reaction is actually opposite to the intention of the managers," Wen says.

The researchers also found that when companies put out good news, the attribution to external or internal factors had no effect.

But this was not the case for bad news. "Our results indicate that when management guidance news is negative, investors make lower earnings estimates when external attributions are provided than when internal attributions are provided," the researchers say.

According to Chen, it comes down to managers' credibility and investors' confidence in whether or not they will be able to fix the problem.

Managers who don't try to blame external factors, even though they may have an apparent incentive to do so, are perceived by investors as more credible and so investors have higher earnings expectations for their companies.

Controllable outcomes

The researchers also looked at whether managers are able to change or influence the outcome/consequence of an action or event.

An internal event is often but not always controllable while an external event is often beyond a company's control. However, while these two factors are highly correlated, they are not the same, says Chen.

While companies cannot control external events, for instance, they can sometimes have some control over the outcome of those events.

"For example, a projected earnings drop can be due to an anticipated rising trend in interest rates [which] is an external factor. However, management may be able to control the effect of such an external shock by engaging in interest rate swaps or by borrowing at fixed rates," Chen says.

The researchers found that investors' earnings estimates are higher when managers attribute their results to an internal factor and the outcome is controllable, compared with when it is internal and outcome is uncontrollable.

Chen says the reason investors mark up controllable outcomes is that they perceive that the company can influence the results, so there is a better chance that managers will be able to fix any problems.

'Profit warnings aren't necessarily a singular occurrence. They can come in twos or threes and that's when a company that might be a habitual profit warner will lose credibility'

GREG SMITH

Open and upfront

Greg Smith, head of research at funds management and investment research firm Fat Prophets, agrees that investors tend to take a more favourable view of companies that report earnings downgrades and cite internal factors as the reason. 

But the opposite is true for external factors. 

"Mining is a good example. You might be the best iron ore producer in the world but if the iron ore price is at $20 or $30 or going lower, then the market's going to probably worry about that more than if it's something that's a one-off," Smith says. 

But it isn't always so clear-cut as controllable and uncontrollable factors affecting a company's profit. 

"If you're a retailer and people aren't spending or if you're an insurer and insurance rates remain depressed, then obviously anything the company does is not really going to be able to help the top line too much," says Smith, referring to the amount of revenue the company earns. 

But they can do other things to help their profits, or the bottom line. 

"There are always things a company can do in terms of their controllable items which is obviously their expenditure side." 

Being open and upfront about an earnings downgrade can help a company, but if it makes further downgrades, then its credibility will suffer. 

"Profit warnings aren't necessarily a singular occurrence. They can come in twos or threes and that's when a company that might be a habitual profit warner will lose credibility," Smith says. 

Temporary or permanent

Monik Kotecha, chief investment officer at Insync Funds Management, says one of the key issues in assessing a company's prospects after it issues negative guidance is whether it attributes the guidance to a temporary or to a permanent factor.

Generally, an internal issue is considered to be temporary and fixable. An external factor can also be temporary. For example, if a soft drink company has poor sales because of a cold, wet summer, that is clearly a temporary factor, and Kotecha says that if stock in the drinks company was "sold down markedly" then it could be an opportunity for investors.

"The market shoots first and then asks questions later," he says. "It all comes down to understanding what were the reasons behind the lowered guidance and what management's response to it is and how credible that is at the end of the day."

Even where there is an external factor for an earnings downgrade, investors still want to be satisfied that management are on top of what is happening in the external environment and how it's affecting their industry and that they have in place a proactive strategy that puts the company in a strong position to the changing environment. This comes down to the quality of management.

The researchers say their work provides useful information to managers about associated costs and benefits when they make choices about what to disclose to investors.

"Attributing negative guidance to external factors ('self-serving' attribution) may be counter-productive if management's intention when issuing external attributions is to pass the buck," they say.

Their second experiment on controllability suggests investors benefit from greater management transparency in terms of the explanations that accompany earnings guidance, though managers may have their own reasons for not wanting to release too much information.