The Week Ahead: Swinging The Focus To The Home Front

This story features NATIONAL AUSTRALIA BANK LIMITED. For more info SHARE ANALYSIS: NAB

By Greg Peel

It’s been a rollercoaster ride recently in the US as extreme volatility has accompanied most every second quarter corporate earnings result. If the US season did anything, it served to highlight the oft-used expression “better than expected”. After one or two earnings reports in Australia last week, this week sees the trickle grow. The weeks commencing August 4 and August 11 see the volume of full year or interim results move into second and third gears respectively, while the weeks commencing August 18 and 25 see top gear and overdrive. Then it stops dead, and we start worrying about AGMs.

For our less market-experienced readers, here’s a little Earnings Season 101.

It makes no difference whatsoever to the potential performance of a particular stock on the day of its earnings release if the company happens to post a record profit or record loss or something in between, as compared to its previous result. All that matters is whether that result is ultimately better or worse than the market “expected”.

It is incumbent upon publicly-listed companies to disclose any information that may be material to shareholders and potentially affect perceptions of value (ie the stock price). This includes providing regular updates of management “guidance” as to what the company itself expects to make or lose in the final reckoning, although while some companies are prepared to “open their kimonos” for all the world to see others are less forthcoming. Unfortunately the issue of what is or isn’t material is a grey one, and you will often hear stock analysts whinging about a “lack of disclosure”.

For full disclosure is the only means a stock analyst has to accurately predict what a company’s earnings result may be, and thus provide a valuation (target price) for the stock. That valuation is also the basis for whether the analyst will declare the stock a Buy, Hold or Sell relative to the current share price. So with whatever information is available to the analyst, which includes both stock exchange announcements and direct open discussion with management, along with price projections where applicable in everything from commodities to costs, currency and economic conditions, an analyst can come up with his or her own estimate of what an earnings result will be.

Take the average of analyst predictions for one company, otherwise known as “consensus” (which is a misnomer because analysts rarely agree), and you have the “expected” profit result. If the actual announced result is then “in line with expectations”, the price of that stock will do little on the day, even if that company just doubled last year’s profit, for example, because expectations have already been “priced in” by the market.

However, if the result is markedly better than expected, known as an “upside surprise”, then that stock should post a rally on the day. Analysts like to be right, but they are not that fussed about upside surprises. They don’t mind so much if a company was hanging on to a bit of good news, which might simply be a sales result that beat management’s own guidance, for example. But the opposite is true for a “downside surprise”.

If a company is hanging on to bad news, this disappoints, frustrates, or even angers both the market and analysts. The sell-off that accompanies a downside surprise is usually more severe than the rise of an equivalent upside surprise. But for a result to “surprise” at all, in simple terms one of two things has happened. Either management has not been sufficiently forthcoming with its disclosure, or the analysts just plain got it wrong. The latter case might involve poor price predictions, or lack of appreciation of cost increases, or any of a number of things. But investors must remember that stock analysts are not omniscient.

Let’s take the tale of two banks. In the US, JP Morgan posted a second quarter earnings result recently that was a horrible 53% loss. However, because consensus was for an even more horrible result, the stock rallied 13% on the day. So did this make it a “good” result? Absolutely not – it was still horrible, and in all likelihood analysts who had been bitten by successive quarters of worse-than-expected results probably erred the other way this time. Analysts are only human (most of them anyway).

In Australia on Friday, National Bank ((NAB)) announced a huge increase in provisions against subprime losses. Analysts were not only angry, they were absolutely seething. This is because not only did NAB suggest that its previous provision was all-encompassing not that long ago, only on Thursday did it roll over a portion of its financing. The providers of that finance were sure in for a rude shock on Friday. This is what you might call text book “poor disclosure”, and NAB shares were duly punished to the tune of a 13.5% fall. Poor disclosure aside, the NAB situation also highlighted that analysts can also potentially be overly optimistic.

Don’t forget, stock brokers will never tell you to stay out of the market, lest they lose potential commissions.

Investors must also note that analysts make earnings estimations not just for the period at hand, but for several periods into the future. This means it is possible that a better-than-expected result can be scuppered if management offers worse-than-expected ongoing guidance. Thus an “upside surprise” may result in a stock price fall if the FY09 guidance becomes a “downside surprise”.

The bottom line of all of this is that result seasons can be a minefield, and in the current environment of enhanced stock market volatility one can wisely say that anything can happen, and probably will.

Now, on to the week ahead.

As the Australian results start to trickle in they meet the back end of the resource sector quarterly production reports. This week is dominated by reports from junior coal miners and oil producers. All the information on timing is available in the FNArena calendar. In the case of economic data it’s a also a relatively busy week both here and in the US.

Monday kicks off in Australia with NAB’s quarterly business confidence survey, not to be confused with the bank’s quarterly business and agribusiness general surveys which are out on Tuesday. Wednesday sees June building approvals, while a busy Thursday brings June retail sales, new home sales, monthly trade balance, and the RBA’s private sector credit growth measurement, all of which feed into the RBA’s perceptions of the state of the economy. On Friday the AiG provides its performance of manufacturing index for July, and the TD Securities/Melbourne Institute monthly inflation gauge is released.

Over in the US, Tuesday starts the week with the Case-Shiller home price index for May, and July consumer confidence. Wednesday sees the ADP private measure of US employment for July, which is a precursor to the official numbers on Friday. Thursday sees another go at second quarter GDP, along with the Chicago purchasing managers’ index for July, and the second quarter personal consumption data. Friday is then the biggie – July employment – along with June construction spending, the July ISM manufacturing index, and July vehicle sales – little volatility time bombs each and every one.

Happy trading.

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