Markets tend to be sceptical about good news, which partially explains the muted reaction to this quarter’s positive earnings numbers. Bad news, on the other hand, is considered far more credible

As earnings season in the US winds down, investors might be feeling rather optimistic. It seems that companies, especially US multinationals, have again exceeded expectations. Over 79% of them have posted earnings per share that beat analysts’ forecasts. This is an exceptionally high number of ‘beats’. It is on a par with the record set for the third quarter of 2009. It is also far better than the average ‘beats’. In a typical earnings season over the past 20 years just 62% of companies exceed analysts’ predictions. The question is why?
 
It is easy to understand why companies would beat expectations in 2009. The global economy was just beginning to recover from the disaster that started in the fall of 2008. The financial community was reeling from a brush with catastrophe. It is reasonable to expect cautious forecasts. The present number might be harder to explain.
 
One possible reason was that the pre-earning guidance provided by companies in the first quarter was very negative. Companies cutting their guidance outnumbered companies increasing it by two to one. The last time this happened again was in 2009, but in the first quarter when the global economy was falling apart. With companies issuing negative signals, the low estimates were predictable.
 
With such distortions we might suspect that managers were intentionally massaging their guidance. Certainly they have large economic incentives to do so. Convincing the market that the company is doing better than anticipated often results in a rise of the stock. Since many executives are also compensated in stock, a bit of a boost never hurts provided that the market actually believes you. This season it was more sceptical. Exceeding analysts’ estimates usually results in a 1% rise in share prices. This time stocks only rose 0.5% for a ‘beat’.
 
One of the economic incentives to manipulating expectation is not so much to create dramatic surprises, but to create a sense of stability. According to a recent survey, 96.9% of CFOs (chief financial officers) prefer a smooth earnings path. A nice earnings graph without spikes or troughs can mean less perceived risk which translates into lower costs for capital, better credit ratings and more credibility with investors.
 
This is especially true for firms which can present earnings as exhibiting a pattern of consistent earnings growth. The core competency of Jack Welch, the former CEO (chief executive officer) of GE, was manipulating earnings. His reputation and fame are based on his skill at being able to ‘manage’ quarterly earnings. He was able to deliver 15% earnings growth every quarter for many years.  Not only did he deliver consistent growth but also managed to slightly exceed expectations.
 
Corporate guidance is a perfect example of asymmetric information. Management has it and you don’t. So one of the ways that quality corporations can increase their value is to signal their ability to consistently forecast and achieve growth. This increases their reputation relative to competitors and other players. Companies with the best reputations, for example those on Fortune’s America’s Most Admired Companies list, are more likely issue more frequent and more precise forecasts than do other companies. The most admired company, Apple Inc, has missed estimates only once since 2007.
 
The credibility of guidance depends not only on the reputation of the company but also upon the type of news itself. Good news is treated by the markets quite differently from bad news. Markets tend to be sceptical about good news, which partially explains the muted reaction to this quarter’s positive earnings numbers. Apparently the market suspects management’s motives.
 
Bad news, on the other hand, is considered far more credible and the market has a much greater reaction. Although the likely credibility is equal for both types of news, bad news can push a company’s stock down by as much as 10%. Since the management realizes that bad news has a greater potential to spark a selloff, the incentives are greater to err on the upside when releasing a negative forecast. Perhaps the greater reaction to bad news has more to do the cognitive bias of loss aversion which is people’s tendency to strongly prefer avoiding losses probably twice as much to acquiring gains.
 
Reducing asymmetry with better disclosure varies a great deal throughout the world depending on the local regulatory regime. Foreign companies listing in New York through ADRs often will voluntarily disclose to increase their reputation. Interestingly disclosure from some companies from the emerging markets of Brazil and India will disclose more than companies from more developed countries. Firms from Denmark, Finland, Greece, Hong Kong, Japan, South Korea, Portugal, and Spain, do not issue any guidance. Firms from Israel, India, Norway, Singapore, and the Philippines issued both more often and more accurate.
 
Perhaps the inaccuracy of companies’ guidance last quarter has less to do with motives than the world economy, which due to massive interference by unpredictable governments, is far simply harder to predict.

(William Gamble is president of Emerging Market Strategies. An international lawyer and economist, he developed his theories beginning with his first hand experience and business dealings in the Russia starting in 1993. Mr Gamble holds two graduate law degrees. He was educated at Institute D'Etudes Politique, Trinity College, University of Miami School of Law, and University of Virginia Darden Graduate School of Business Administration. He was a member of the bar in three states, over four different federal courts and has spoken four languages. Mr Gamble can be contacted at [email protected] or [email protected]).