The 5-point earnings results checklist

By Ben Rundle | Portfolio Manager at NAOS Asset Management

Recently in his famed afternoon stock market summary, Richard Coppleson from Bell Potter outlined his observations from 290 stocks that reported earnings results back in February 2019. His findings revealed that the share price move for the 20 worst performers averaged -15% on the day they reported. These are large moves and display a level of volatility that can be quite difficult for many investors to stomach. 

Below I have provided a five-point earnings results checklist to help investors navigate the upcoming reporting season.

“Volatility is a welcome creator of opportunity” - Seth Klarman

1: Reality versus expectations

The two most common factors that determine market expectations leading into an earnings result are:

• The previous guidance given by a company prior to the result, or 
• The collective research analysts ‘consensus’ for what they believe the result should be.

 It is not uncommon for both of these numbers to differ wildly from the actual result and hence share price moves on reporting day can border on the extreme. 

Looking at these headline figures, while being the first logical step to assessing a result, is an incomplete way of judging how the company is going. Just because a company missed expectations it doesn’t necessarily make it a poor company.

2: Cashflow is King

Next, we want to delve into the cashflow. In our view, the best way to read a financial report is back-to-front – i.e. start with the cashflow statement at the back and then work towards the profit and loss statement at the front. 

Due to varying revenue recognition policies and accrual accounting, the profit and loss statement will not always give a true indication of what the cash earnings of the business have been during the period. 

There is often a misconception that if profits are strong then the company should be able to meet its financial obligations, however, it is not uncommon for a company to announce a positive profit figure, but the actual cash received paints a very different picture. 

The now failed Blue Sky Alternative Investments (ASX: BLA) was a good example of a company with positive profits, but poor cashflow.

3: Result quality

Beyond cashflow, we want to know if the company has a strong balance sheet and whether they are growing key financial metrics.

NAOS particularly like to focus on return on invested capital (ROIC) and return on equity. However, what is even more important is the ROIC trend and whether the company has options available to deploy excess capital at similar rates of return to how they have done in the past. A company with a high but declining ROIC will often eventually see a declining share price, while an increasing ROIC can drive a rising share price.   

Cleanaway Waste (ASX: CWY) is a good example of a company that on face value looks to have low ROIC, however since the current management team has been in control, the incremental return on capital has been improving and the share price has increased significantly.

Similarly, we like to see companies that are showing evidence of margin expansion. This is especially powerful for a company that has a fixed cost base. If the cost base can stay relatively static while the top line grows, then that fixed cost leverage will drive the bottom line much faster than the top. If this happens, you are likely to see multiple expansion and therefore a share price re-rate higher.

4: What has previously been said?

If you really want to understand a company, we find one of the best ways to do so is to read company announcements from the last five years. 

It won’t take as long as you think, and it will give you a very good idea about what management’s strategy looks like and how they have executed it. Remember you are buying a business and not a stock code. 

This point particularly relates to capital allocation. Did the company make an acquisition over the past few years that they were excited about at the time, but it has now been swept under the rug? Have they been sticking to their stated strategy or has it changed along the way? 

Working out whether the management team has a consistent strategy year-on-year will go a long way to knowing whether you are buying a quality company.

5: What does the outlook involve?

Finally, the outlook gives us a better picture of what to expect from the company going forward. It is quite customary for market participants to forget a poor year in place of a rosy outlook. Most of the companies reporting in the upcoming results period will be reporting their full-year FY19 numbers and it is therefore rare to see companies guide on how FY20 is looking. 

We will often place a healthy level of scepticism on companies providing guidance for FY20 unless they have a highly predictable earnings stream. An overconfident management team that sets expectations too high will set themselves up for a poor year of share price performance if they don’t deliver. We much prefer a conservative management team who is aware that business conditions can change, and the business cycle is exactly with it.

The initial share price reaction on the day of an earnings announcement can come with a high level of emotion. A stock that is sold off heavily will lead the crowd into an irrational thought process which can lead to irrational selling. 

Remember that the stock market can be a very useful tool for transferring wealth from the impatient to the patient. Even great companies will experience periods of underperformance and it is during these times where an opportunity to buy more can often present itself.

This article first appeared on Livewire, 29 July 2019

Important Information: This material has been prepared by NAOS Asset Management Limited (ABN 23 107 624 126, AFSL 273529 )and is provided for general information purposes only and must not be construed as investment advice. It does not take into account the investment objectives, financial situation or needs of any particular investor. Before making an investment decision, investors should consider obtaining professional investment advice that is tailored to their specific circumstances.