Should you believe companies that promise a better tomorrow?

Recently, a large number of companies have fallen short of market expectations. Some of them have made poor strategic decisions, others have been hurt by macroeconomic conditions, and possibly a few have made poor strategic decisions but blamed it on macro conditions.

iSentia Group Ltd (ASX: ISD), Flight Centre Travel Group Ltd (ASX: FLT) and OFX Group Ltd (ASX: OFX) (formerly OzForex) are just some of the companies that have reported disappointing first halves recently.

They’re joined by Blackmores Limited (ASX: BKL), Ainsworth Game Technology Limited (ASX: AGI), and half-a-dozen others whose names escape me right now. Reasons behind the declines at these companies vary, but the story is the same:

The first half was bad, but the second half will be better.”

Some companies are even suggesting that full year earnings will be significantly up compared to last year, despite the first half coming in much lower.

Unless the global economy is preparing for a big upswing, it seems unlikely that all of these companies with their diverse businesses are all going to see a significant improvement in operating conditions in the second half.

So, what’s a shareholder to do?

  • Follow the story

Every company has a story. Flight Centre’s poorer performance is because lower airfares have seen it struggle to generate the same level of commissions from airlines.

So if that’s the cause for the lower earnings, investors need to ask if airfares are going to rise. Flight Centre itself often reports major route prices (e.g. Sydney – Los Angeles) in its reports, so investors can track these over time.

As an interesting aside, I discovered an article on the web from 2005 describing a similar situation with Qantas Airways Limited (ASX: QAN) cutting Flight Centre’s commissions. Flight Centre shares have doubled since then, plus dividends.

  • Evaluate management

Can you trust management?

Are they forecasting a reasonable improvement, or just hoping for one? There’s no easy answer to that question. If you’ve been following the company a while, you can get a sense of whether directors are clear with shareholders, or whether they act to hide what’s really going on.

A number of famous investors recommend ignoring the tone of management’s announcements to focus on the substance – does management do what they say they will do? Yet investors must also be aware that the market demands forecasts from companies – you need to assure yourself the company is not trying to forecast the unforecastable.

In its recent trading update, Ainsworth said it is selling less gaming machines to Australian casinos which is hurting profits. Based on a number of factors, the company also said that profits should be substantially higher in the second half of FY 2017.

If profits aren’t up at that time, either management’s forecasts were wrong or they got caught out by unforeseen circumstances, or they haven’t been completely frank with you – those are the only possible explanations.

You will likely be able to form a reasonable first impression of Ainsworth management when the full year 2017 report comes in, whatever the results are.

  • What’s the downside?  

If management is wrong, what’s at stake? Although each company’s share price can only go as low as zero, as long as the company is not going bankrupt, businesses with a higher Price to Earnings (P/E) ratio and/or greater debt will be hit harder by missed forecasts.

If Flight Centre’s Earnings Per Share (EPS) fall by 1 cent,  the company’s share price will theoretically fall by 12 cents (P/E of 12). That same move at Blackmores, for example, would result in a 20 cents decline. The downside is actually worse at Blackmores because the market could also re-rate the company’s P/E ratio to 15 instead of 20 for example and multiply the losses.

The worst combination would be something like Isentia which had (until yesterday) a high price to earnings ratio and no tangible assets to underpin its valuation. Earnings were downgraded, the price to earnings ratio fell, and much of the company’s value now hinges on the accuracy of management’s forecasts for the second half.

Foolish takeaway

As we have seen above, investing is not always as simple as just taking management’s word that things are improving. Investors must also consider management’s track record, as well as the potential downside if forecasts don’t come true.

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Motley Fool contributor Sean O'Neill owns shares of Flight Centre Travel Group Limited. The Motley Fool Australia has no position in any of the stocks mentioned. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

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