Four times a year the financial media feels the need to dramatically parade the quarterly performance of America’s biggest companies across our television screens and internet pages. It’s January, and the dog and pony show is back. I don’t mean to downplay earnings as they are indeed important. Successful businesses must continue to generate profits. What isn’t important is the over-hyped focus on short-term results.

On the topic of quarterly earnings I’m always reminded of the Jason Zweig’s excellent book Your Money & Your Brain. Here’s an excerpt that speaks to the madness that sometimes takes place:

“On September 28, 2000, Apple Computer Inc. announced that its quarterly earnings would be about $55 million less than it had previously estimated. At about 27% better than the same period a year earlier, it was hardly a poor result. But Wall Street’s analysts were expecting Apple to do even better. The next trading day, Apple stock fell by 52%, vaporizing $5 billion of the company’s total market value. For each million dollars of Apple’s shortfall in earnings, Wall Street slashed the market capitalization of the stock by more than $90 million.” [1]

The example is a little dated, but it teaches us to be wary of what we think is reputable information coming from Wall Street analysts. Their expectations don’t exactly provide tremendously good insight as to how a company will perform in any given quarter. The chart below summarizes the percentage of companies from the S&P 500 that beat, missed (underperformed) or met their earnings estimate.

Data Source: Standard & Poors

Several things stand out. First, there is a surprising consistency to this data. Quarter after quarter the results look nearly identical (within a few percentage points). Second, analysts were only able to accurately forecast company earnings about 10% of the time. Ten-percent! Third, a majority of companies (approximately two-thirds) generated earnings in excess of what analysts were expecting. A set of consistent data demonstrating positive out-performance usually draws a degree of caution and skepticism from myself. Some recent commentary on Bloomberg had this to say regarding the Lake Wobegon-like trend

The real answer may only be known by the analysts and their priests, rabbis or mullahs — or maybe the managing director who sets their bonus. One popular and plausible theory is that companies give low-ball guidance and analysts dutifully set their estimates accordingly. [2]

In truth the above data makes it difficult to quantify the accuracy of analyst forecasts. Earnings that come in above the forecast by $0.01 and $1.00 are both considered to have beaten estimates, while the former would represent a more accurate prognosis. The real problem here is that focusing on earnings on a quarterly basis neglects the bigger picture. Consider after tax corporate profits and GDP. Both have grown at approximately 6.5% nominally since 1947.

	Annualized Growth Rate
	Nominal	Real
GDP	6.50%	2.90%
Corp. Profits	6.81%	3.19%
Sources GDP: https://research.stlouisfed.org/fred2/series/GDP# Corp Profits: https://research.stlouisfed.org/fred2/series/CP

The above values would imply a reasonable outcome for investors. The profits produced through equity ownership in corporate America have grown at a similar rate to GDP over the long-term. The problem with this conclusion is that it neglects changes in the number of outstanding shares. While corporate profits have grown at essentially the same rate as GDP, earnings per share have not. From 1929 through 2014 real GDP growth again clicked along at a 2.99% real rate while S&P 500 real EPS grew at only 1.83%–a 1.16% annualized lag. Bernstein and Arnott discussed the difference between aggregate economic and per share performance in a 2003 paper for the Financial Analysts Journal. [3] Their analysis shows the lag in per share performance is a more dismal 2%. Additionally this per share performance lag was caused by share dilution–that is more new shares were issued than were repurchased. The phenomenon was not unique to the United States as countries around the world exhibited a similar dilution in per share performance with respect to GDP growth. They offer a more humbling outlook

In short, the equity investor in a nation blessed by prolonged peace cannot expect a real return greatly in excess of the much-maligned dividend yield; the investor cannot expect to be rescued by more rapid economic growth. Not only is outsized economic growth unlikely to occur, but even if it does, its benefits will be more than offset by the dilution of the existing investor’s ownership interest by technology-driven increased capital needs. [3]

Thus there are two major conclusions for long-run investors: corporate profits have grown at approximately the same rate as GDP and per share performance has been impeded by the issuance of more shares. Not so great news for the individual investor. Of course neither of these facts makes for exciting television nor do they help increase page views.

References
1. Zweig, Jason. Your Money & Your Brain. Simon & Schuster. 2007. p. 182.
2. Regan, Michael. Here’s Why No One Cares Anymore That Your Profit Beat Estimates. Bloomberg. 15 July 2015. http://www.bloomberg.com/news/articles/2015-07-15/here-s-why-no-one-cares-anymore-that-your-profit-beat-estimates.
3. Bernstein, William J. and Robert D. Arnott. Earnings Growth: The Two Percent Dilution. Financial Analysts Journal. September/October 2003. pp. 47-55. https://www.researchaffiliates.com/Production%20content%20library/FAJ-2003-Two-Percent-Dilution.pdf
Data for 1929 through 2014 period
GDP: http://www.bea.gov/national/index.htm#gdp
EPS: www.econ.yale.edu/~shiller/data/ie_data.xls

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What I’m Reading
How To Be Less Terrible At Predicting The Future (Freakonomics)
An Interview With Ron Rhoades (Barry Ritholtz)
The Confounding Bias for Investment Complexity (Research Affiliates)
SEC Approves Plan to Issue Stock Via Bitcoin’s Blockchain (Wired)