Drinking from a fire hose

With the latest half-yearly reporting season now over, it’s a good time to reflect on our investments. At least, that is, in a more considered way than is possible in the heat of the moment. The spray of numbers, often coming from multiple companies on the same day, can be extremely hard to digest. It’s like drinking from a fire hose.

Of course, it doesn’t take much to compare sales or earnings with company guidance or analysts’ forecasts. Especially when the associated share price movement will typically tell you how well things lined up. Shares down? Guidance missed. Shares up? Better than expected!

Sadly, that’s about as deep as many investors go. It’s an approach that lacks context and can lead to very poor decision making.

The reality is that, for the vast majority of companies, accurately forecasting what sales or earnings will be in six months’ time is exceptionally hard. Even for management. Guidance will almost always come in above or below what was expected and, in isolation, that usually says very little about the long-term prospects of a company.

Remember, the true value of a company, rationally defined, is the sum of all future cash flows, discounted back to their present value. There’s a lot to unpack in that sentence, but the key point is that even a reasonably large deviation from what the market was expecting in a given half should not have a particularly big impact on our notion of value — all else being equal.

Yet such a ‘miss’ to guidance can lead to substantial changes in market price.

Are you really buying shares in a company because you have specific expectations for what earnings will be in six months? Or is it more about what the general trajectory is likely to be over the coming years?

We have to be mindful, too, that there are ‘good’ reasons why a company may deliver worse than expected results. Maybe the company experienced an unfortunate contract loss that had nothing to do with their offering, and everything to do with the customer’s own ill-fortune.

Perhaps it’s just the inevitable vicissitudes of the wider economic environment. No business operates in a vacuum.

JB Hi-Fi (ASX:JBH) has fallen short of analysts’ near-term forecasts on many an occasion, and yet the business has grown its sales, dividends and book value by well over 10% per year, on average, over the past decade. Of course, it is that general trajectory that has underpinned long-term shareholder returns, not the accuracy of brokers’ half-yearly earnings estimates along the way. (By the way, why do we say that the company missed guidance — isn’t it the analysts that were wrong?)

On the other hand, Myer (ASX:MYR) has, at times, exceeded market expectations in certain periods, while all the time slumping further into economic obsolescence. 

Cyclical swings are nothing to worry about, and the market’s over-reaction can in fact present great opportunities to those with a longer term focus. Businesses facing structural challenges, on the other hand, are usually best avoided even if the deterioration is slower than the market initially assumed. 

Ironically, decisions that are in the best long-term interests of a business and its shareholders can sometimes result in a savaging by the market. Investments made to strengthen competitive advantages, or develop the foundations for future cash flows, will always reduce the cash available to shareholders in the near term, but are nevertheless vital for longer-term prosperity. Sadly, the market isn’t always understanding of management that think beyond next year’s numbers.

Remember, long term prospects are what define value, and there’s subtlety and nuance behind every reported metric. Go beyond the headline, and put reported results in context. 

Happy investing!

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