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Earnings Season: Time to Tweak Warren Buffett's Maxim

A favorite saying of Warren Buffett’s has bearing on the latest quarter’s corporate results.
ENLARGE

A favorite saying of Warren Buffett’s has bearing on the latest quarter’s corporate results.


Photo:

Reuters

By

Justin Lahart

April 11, 2016 1:17 p.m. ET

Warren Buffett likes to say that you only find out who has been swimming naked when the tide goes out. With earnings season looming, investors also should be careful with companies that appear fully clothed.

The first quarter was another tough one. Analysts polled by Thomson Reuters I/B/E/S estimate earnings for S&P 500 companies fell by 7.5% from a year earlier. It is the kind of environment in which the shares of companies that are able to keep notching good results are richly rewarded.

The trouble is those rewards can also tempt companies to overstep the bounds for fear of swift punishment.

For a recent project, Patricia Dechow, an accounting professor at the University of California, Berkeley’s Haas School of Business, and three co-authors screened for nonfinancial firms that were subject to enforcement actions for misstating earnings at some point between 1994 and 2010. They then looked at how their earnings compared with analyst estimates during the misstatement period.


ENLARGE



Their finding: 53% of misstating firms topped estimates for at least four consecutive quarters versus 43% for other firms. That is significant.

For an example of a company that, until recently, was racking up impressive earnings stats, investors need look no further than Valeant Pharmaceuticals International.
VRX


-2.81
%




In the five years that ended in last year’s third quarter, it topped analysts’ median estimates 18 times and met them twice. The streak ended last month when Valeant finally released unaudited fourth-quarter results that fell short of estimates.

Now, doubts are swirling over Valeant’s past results. It has said that it wrongly booked $58 million in revenue in 2014, that it is under investigation by the Securities and Exchange Commission and that it is unsure when it will file audited 2015 financials. Its stock is nearly 90% below its peak in August.

While the book isn’t yet closed on what happened at Valeant, investors should consider if estimate-beating results weren’t actually a warning sign.

As they ponder that, investors should consider a broader question: What leads a company to game earnings? One theory is greed: Management wants to push the stock higher. Another theory says it is fear: Management is worried about seeing the stock tank.

It looks like fear plays the greater role. The researchers found that forward price/earnings multiples for companies with strings of earnings beats that fell afoul of the SEC were elevated before the period when they misstated earnings. During the misstatement period, valuations tended to stay rich, but not get any richer.

So the probable explanation is that companies generally got rewarded with P/E ratios on a run of good results, but weren’t able to keep delivering. For managers who had been enjoying the fruits of a high valuation, this was hard to take.

An especially big worry: Shares of companies with a history of positive earnings surprises tend to get severely punished after misses. So that raises the stakes for these companies.

And those are particularly high today when overall U.S. profits have been flagging after a long period of growth—the tide is going out. Before rewarding a company that seemingly has avoided the earnings slowdown, investors need to be sure it isn’t just wearing the emperor’s new swimming suit.

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Earnings Season: Time to Tweak Warren Buffett's Maxim Reviewed by on . ENLARGE A favorite saying of Warren Buffett’s has bearing on the latest quarter’s corporate results. Photo: Reuters By Justin Lahart Justin Lahart The Wall Stre ENLARGE A favorite saying of Warren Buffett’s has bearing on the latest quarter’s corporate results. Photo: Reuters By Justin Lahart Justin Lahart The Wall Stre Rating:
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