Earnings bluff and double bluff…

It’s one of the staples of the airport thriller novel — the spy who’s a double agent, or is he? The game of bluff and double bluff. He’s an American spy who’s really a Russian spy… or maybe that’s the bluff.

While perhaps not as exciting or mysterious, there’s an element of the spy thriller happening on the ASX as we approach the last leg of earnings season. Take yesterday, for example.

Up is down and down is up

Seven West Media (ASX: SWM) reported earnings yesterday. Revenue was down 3.6%, operating earnings before significant items fell 1.7%, and the bottom line (after those significant items are added back) fell from a $227 million profit last year to a loss of $70 million in 2013. The bluff? Shares rose 5.6%

On the other hand, undies-to-pillows business Pacific Brands (ASX: PBG) suffered a slight fall in sales (down 3.7%), but recovered from a $451 million loss last year to turn in a $74 million profit and increased dividends by 11%. The twist in the tale was a 7.7% share price fall.

It’s a story that’s been repeated day after day in the past three weeks. Many an investor, seeing the headline results, has been shocked by the subsequent share price movements.

Short of some international government subterfuge, there are two key reasons why earnings and share prices diverge.

Expectations and guidance

The first is expectations. Some companies make the effort to carefully guide investors’ expectations prior to the earnings release — the big end of town doesn’t like surprises, you see. More often than not, earnings comes in somewhere around those expectations, but even in those cases, a small miss can see the shares sold off — even if the profit numbers show impressive growth on the prior year.

The second is the company’s ‘outlook’ guidance for next year. Assuming the company doesn’t deliver any huge surprises in the current year, investors move — as they should — to thinking about the future. In sport, you might only be as good as your last game, but in business, especially on the stock market — you’re only as good as your next earnings release.

Again, many companies don’t provide such guidance — either because the future is too uncertain, or simply because they try to play a longer game, and avoid getting caught up in the short-term. We applaud the latter, but the market doesn’t always agree. “The market hates uncertainty” goes the refrain, and that can make for a volatile share price.

Of course, worse than not giving guidance at all is giving guidance that suggests the future isn’t as good as the past, or as good as investors’ expectations. Yes, it turns out that even when it comes to guidance, expectations matter!

Whipsaw on a whim

The market is happy to whipsaw prices this way and that, looking only at the last 12 months and, sometimes, the next 12. It would be laughable if it didn’t involve many billions of dollars! Can you imagine, at Woolworths’ results in 1993 when the share price was under $3.00, and making a buy or sell decision based on that 12-month period only? Indeed, Woolworths price dipped by almost 20% during 1994. Those who sold before, during or after that were either congratulating themselves or kicking themselves for losing 20% before they got out. The share price is now comfortably north of $33.00! Now both groups should be kicking themselves.

There is little more futile than trying to make investment decisions with a 12 month time horizon. Of course, I’m not suggesting that investors buy and hold regardless. A terrible business doesn’t get any better just because you don’t sell it. Warren Buffett said “time is the friend of the wonderful business, the enemy of the mediocre”.

The mediocre business doesn’t deserve a place in your portfolio, and the wonderful business deserves your patience — as long as you buy the shares at an attractive price in the first place, and while the long term future looks bright.

Simple. Foolish. Profit.

When it comes to earnings season, investors should be asking themselves “is this a business that I think is worth holding for the next ten years?”. If not, it doesn’t belong in your portfolio. If it is, then each earnings release should be an opportunity to assess the business’ progression towards its long term goals — not as a catalyst to buy or sell based on a single set of numbers.

Our formula is simple. We recommend companies we think have the best chance of beating the market over the long term.

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