Optimistic Managements = Poor Capital Allocation = Stock Underperformance

gcopley
Print Friendly
Share on LinkedIn0Tweet about this on Twitter0Share on Facebook0

SEE LAST PAGE OF THIS REPORT FOR IMPORTANT DISCLOSURES

Graham Copley / Nick Lipinski

203.901.1629/203.989.0412

gcopley@/nlipinski@ssrllc.com

March 11th, 2015

Optimistic Managements = Poor Capital Allocation = Stock Underperformance

  • Our prior work has highlighted the widespread underperformance of companies that habitually adopt an overly optimistic outlook – these companies continually set themselves up for negative revisions and stock price underperformance..
  • This embedded optimism reflects itself more broadly in poor capital allocation decisions that erode return on capital. See the left chart of Exhibit 1 below. Managements that seem content to be continually optimistic about their earnings outlook have higher capital spending levels with commensurate lower returns.
  • This result holds nearly any way we slice the data and on a number of metrics, for the broad Industrials & Materials space, on a sector neutral basis, and within our large cap universe. It also holds when we analyze 10 year averages, discrete years and quarterly trends.
  • We quantify optimism on an annual basis by comparing a company’s full year EPS estimate on January 1 to the actual reported result. The central assumption is that estimates are based on explicit/implicit corporate guidance and as such are reflective of a company’s view.
  • The right chart of Exhibit 1 represents 10 year average metrics for the 20 most optimistic companies in our universe (ex. Metals) and the 20 most conservative. The outcome remains consistent from the original work – optimists underperform.
  • Drilling down to the sector and stock level, we look for those companies which appear on both the annual and quarterly optimism and pessimism cuts. On average the current optimists have already seen year-to-date negative EPS revisions five times in excess of what the conservative group has seen. Estimates call for a modest 2% EPS growth for the conservative group versus 26% EPS growth for the optimists in 2015. A list of these companies is shown in Exhibit 10.
  • In Exhibits 13 and 16 we show the names that are at the extremes both within the large cap arena as well as within each sector.
  • CYT stands out currently as the most expensive stock in the Optimist group; the agricultural names (DE, AGCO) show the greatest value among the Conservatives.

Exhibit 1

Source: Capital IQ and SSR Analysis

Overview

Beyond traditional operational and capital allocation responsibilities, corporate management has a key role in setting expectations for the investment community – some companies are clearly more effective at both understanding and managing the outlooks for their businesses than others. Exhibit 2 shows that the correlation between annual performance and the revision to that calendar year’s EPS estimate from January 1 to December 31 is considerable for our group of companies. The underperformance of optimistic companies, shown in Exhibit 1, is not a singular phenomenon, but rather holds over a number of time frames and on a sector neutral basis as well. Further, Exhibit 3 shows that the companies most conservative in their initial guidance are outperformers not only with respect to their more optimistic counterparts, but relative to the broader Industrials & Materials universe as a whole. Our prior work on this subject looked at optimism on an annual basis over a period of 10 years (from 2002 to 2011 in the original work from 2012, the left chart in Exhibit 1 is updated to reflect 2005-2014). The outcome remains consistent throughout – optimists underperform.

Exhibit 2

Source: Capital IQ and SSR Analysis

Exhibit 3

Source: Capital IQ and SSR Analysis

Our optimist and conservative groups – as detailed later – are shown in the chart below ranked by current value – we would be favorable towards the cheap conservatives (above the line green bars) and cautious towards the expensive optimists (below the line red bars) based on this analysis alone.

Exhibit 4

Source: Capital IQ and SSR Analysis

Optimism on a Quarterly Basis

Exhibit 5 below looks remarkably similar to Exhibit 1, but here we are looking at the consensus estimate at the beginning of the quarter (January 1 for Q1, April 1 for Q2, and so on) versus the actual result. The analysis covers Q1 2012 through Q4 2014. As with the annual data, if we compare the two subgroups with our broader universe, we see the same stratification – optimistic companies lag the group, conservative ones outperform.

Exhibit 5

Source: Capital IQ and SSR Analysis

The Annual Cut – Optimists Year In, Year Out

For both the 10 year annual (Exhibit 1) and 3 year quarterly (Exhibit 5) optimism results, we have cut the data a single time, based on the cumulative average percentage difference between the actual EPS result and the estimate at January 1 of that year (or the first day of each quarter). In Exhibit 6 below we have sorted the results for EACH of the past 10 years, giving us 10 sets of 20 optimists and 20 conservatives. Without fail, the optimist group has underperformed significantly – the average differential in performance between the two groups is 33%, with a standard deviation of 15%. Note that we have used 13 month performance to capture some of the price reaction associated with Q4 reports (which often fall outside of the calendar year). So 2005 performance, for instance, reflects the period from January 1, 2005 to January 31, 2006.

Exhibit 6

Source: Capital IQ and SSR Analysis

Below we show the companies that appear most often in each group over the past 10 years – Exhibit 7. The frequently optimistic companies are composed of mainly Chemical stocks (ASH, CYT, CBT, and DOW) with three Electrical Equipment manufacturers (BGC, GTI, BDC) and one Capital Goods name (TKR). Interestingly, the conservative group is dominated by the cyclical Capital Goods space (TRN, SNA, VMI, AGCO, CMI, and OSK). We note that the composition is to some extent influenced by the varying number of stocks within each sector – we have 30 names in our Capital Goods index versus 14 in our Paper & Packaging index for instance. We address the possibility of sector bias in a later section – click here to jump to the sector by sector optimism results, where we find the conclusion of optimist underperformance also holds.

Exhibit 7

Source: Capital IQ and SSR Analysis

Exhibit 8

Source: Capital IQ and SSR Analysis

Optimists & Conservatives at the STOCK Level

Exhibit 9 lists the constituents of each group, for both the annual (Exhibit 1) and quarterly (Exhibit 5) optimism results. Companies appearing in the optimist/conservative group on both cuts are highlighted in bold.

Exhibit 9

Source: Capital IQ and SSR Analysis

In Exhibit 10 below we show year to date 2015 EPS revisions, recent EPS history, average growth from 2010 to 2014, and implied 2015 growth over 2014 levels for the bolded companies above as well as those that did not make this overlap group but have among the highest number of appearances on each list (shown in Exhibit 7).

Year to date, the optimist group has on average already seen negative EPS revisions five times greater than the conservative group. In aggregate the optimist group is implying 26% growth over 2014 EPS figures, compared to 2% for the conservative group – this is despite the recent history which predictably shows EPS growth for the optimists has been nearly one third of that for the conservative group. Note that even absent the cyclical declines in the agricultural machinery stocks (AGCO and DE), consensus sees only 9% consensus EPS growth for the conservatives in 2015.

Exhibit 10

Source: Capital IQ and SSR Analysis

Our Large Cap Universe Shows the Same Results

The overall annual and quarterly analysis for the full group shows a decent number of small and mid-cap companies. To test optimism exclusively at the large cap level, we restricted the analysis to the stocks in our coverage with a market cap in excess of $10 billion. Of the 38 stocks meeting that criterion, we took the 10 most optimistic names and the 10 most conservative. We see the same results on the metrics used in the annual and quarterly work. ROC trend analysis similarly supports the conclusion of optimist underperformance and capital misallocation (see the next section on optimism at the sector level for more detail on the ROC work).

Exhibit 11

Source: Capital IQ and SSR Analysis

Exhibit 12

Source: Capital IQ and SSR Analysis

Exhibit 13

Source: Capital IQ and SSR Analysis

Optimists & Conservatives within SECTORS

The optimist and conservative groups are composed of a fair mix of stocks from across our sectors, with perhaps a slight skew towards Capital Goods and Chemical names by simple virtue of the larger number of stocks in these sectors. We tested for the effect of sector bias by taking the top three optimistic and conservative companies in each sector, sorted by the 10 year average results. The method is identical to that behind the data in Exhibit 1, but here we make the selections within sectors and with a necessarily smaller subset (three companies on either end from each sector). Exhibit 14 shows the average annual performance delta between the optimists and conservatives within each sector. The results are robust and hold for every sector with the exception of E&C, where we note the sample size was restricted to two optimistic and two conservative companies due to the lack of 10 year history for two of the six names in our E&C coverage.

Exhibit 14

Source: Capital IQ and SSR Analysis

The effects of optimism extend beyond performance, and seem to be intertwined with the broader issue of capital misallocation. For the companies represented in the performance data in Exhibit 8, we took the monthly ROC history from our models, averaged the optimists and conservatives in each sector and made a trend off the average. We then determined the annual growth rate of the ROC trends and compared the difference between the optimist and conservative groups. The left chart of Exhibit 15 illustrates the ROC trends, here for the Chemical sector as an example. The results for each sector, generated by the identical analysis, are shown in the bar graph on the right. With the exception of the Paper & Packaging sector, the conservatives consistently show a superior history of growing return on capital at a faster pace than more optimistic companies

Exhibit 15

Source: Capital IQ and SSR Analysis

Exhibit 16

 

Source: Capital IQ and SSR Analysis

©2015, SSR LLC, 1055 Washington Blvd, Stamford, CT 06901. All rights reserved. The information contained in this report has been obtained from sources believed to be reliable, and its accuracy and completeness is not guaranteed. No representation or warranty, express or implied, is made as to the fairness, accuracy, completeness or correctness of the information and opinions contained herein.  The views and other information provided are subject to change without notice.  This report is issued without regard to the specific investment objectives, financial situation or particular needs of any specific recipient and is not construed as a solicitation or an offer to buy or sell any securities or related financial instruments. Past performance is not necessarily a guide to future results.

Print Friendly