Jonathan Davis: In this market, the innocents suffer along with the guilty

'What is dragging the market down are the few big companies missing expectations by a wide margin'

One of the main reasons stock markets have again been falling is the evidence that corporate earnings have been coming in well below expectations. Like all statements about the market as a whole, even such a simple one as this turns out not to be quite as straightforward to interpret as it first appears. For one thing, it begs the question whether it is poor earnings or excessive expectations that are most to blame.

Money net

One of the main reasons stock markets have again been falling is the evidence that corporate earnings have been coming in well below expectations. Like all statements about the market as a whole, even such a simple one as this turns out not to be quite as straightforward to interpret as it first appears. For one thing, it begs the question whether it is poor earnings or excessive expectations that are most to blame.

First, there is a lot of variation from one stock to another. In the Footsie 100 index, for example, there are a sizeable minority of companies whose earnings estimates are being revised upwards rather than downwards.

Overall, the number of disappointments outweigh the number of positive surprises, but the picture itself is more mixed than the headline figures suggest. Despite all the nonsense that pours out of many corporate headquarters about loss of "earnings visibility", a fair number of high-quality companies continue to churn out perfectly respectable high single-figure or double-digit earnings growth. Charles Dunstone, of Carphone Warehouse pleased the market this week, but he was in a minority.

Secondly, what is dragging the market down particularly hard are a few companies that are missing market expectations by a wide margin. Companies suffering the worst disappointments are often, unsurprisingly, the slowest and least effective at communicating their concerns to the marketplace.

By definition, it is much easier to manage investors' expectations if you are running a large, branded business with powerful franchises and lots of pricing power, than if you are a second-rate industrial company whose customers are deserting in droves and where the bank manager is sitting in reception demanding to be seen.

Thirdly, the whole game of managing earnings expectations is changing. You may recall how even before Enron and the other accounting scandals started breaking that the Securities and Exchange Commission introduced new so-called "fair disclosure" rules in the US market. These were designed to replace the insidious practice of companies giving selective private briefings to analysts about future earnings with the principle of simultaneous public disclosure of any earnings-sensitive information.

This has led to the practice of companies getting into the "market guidance" game, that is, making regular public statements about their future earnings prospects and how their internal figures stand in relation to the consensus estimates of the market. This has not stopped investors and analysts from continuing to hold inflated expectations about many companies' prospects.

Now that earnings figures themselves have coming increasingly under the spotlight, and companies are having to justify their figures with more rigorous accounting, it is obvious that if making stock selection on the basis of forecast earnings is your game, the rules and the quality of the raw material have now turned against you. This may be a temporary effect, and once the various accounting and regulatory changes have been absorbed, it will be easier to place more faith in future earnings projections. But at present it is a hazardous game.

The profession of sell-side analyst (if it can be called a profession) has gone seriously ex-growth, as their steady exodus from banks and broking firms bears witness. Many analysts at broking firms became captives of their firm's investment banking or corporate broking arms during the great bull market, and abandoned any pretence of independent analysis in favour of becoming accomplices to stock promotion, as the recent disclosures about the goings-on at some of the biggest investment banks makes clear.

It is little surprise that earnings figures are causing so much disruption. Investors are already jittery, and their lack of confidence in earnings projections is spreading like a contagion. The market is punishing most heavily those firms that produce the biggest earnings disappointments, but companies with the best earnings momentum continue to outperform the rest of the market.

The most encouraging news is that, as often happens, the contagion is spreading not just to those stocks that deserve the re-rating but others that arguably deserve more favourable treatment. Research by CSFB shows the 20 per cent of European stocks with the best earnings momentum have outper- formed the market by 10 per cent since the start of the year, and the 20 per cent with the worst experience have underperformed by 15 per cent. But, in absolute terms, many of the virtuous are still suffering along with the rest, as always happens in bear markets.

It is reaching the point, as was noted here a few weeks ago, that it is at last producing genuinely interesting buying opportunities, at least for those with reasonably medium-term horizons. The market may yet break through its late summer lows and extend the bear market by one further leg – it is hard to say market sentiment is positive at present – but the number of large, well-capitalised stocks that have strong, consistent earnings records as well as, in many cases, healthy dividend yields is increasing by the day. Some are worth adding selectively to your stock watch list.

Remember that bear markets, when they do end, tend to do so suddenly, and when they do, it is because investors have forgotten about the need to look at fundamental value and are instead so bewitched by the day-to-day price movements that they have lost sight of the more important issues, just as they do the other way round at the top of a bull market.

davisbiz@aol.com