by Ben Claremon | Research Analyst

Welcome to earnings season and the barrage of company press releases and conference calls. Securities analysts all over the country currently have their noses buried in 8-K’s and 10-Q’s, hoping to get a sense of company-specific and industry trends. After personally reading through the transcripts of and listening to a number of conference calls, one common theme became very clear. First and foremost, analysts want to know if companies are seeing a slowdown in demand for their products and services. Given all of the turmoil over the last few months, everyone is justifiably concerned about the state of the global economy. Some companies, such as Federal Express (FDX), are anticipating record holiday shipments and are adding workers. As such, it should not come as a shocker that FDX’s shares were up nicely upon its earnings release. Alternatively, the management team of 3M (MMM) indicated that it is seeing a slowdown in demand from its customers due to economic weakness, especially in Europe. Not surprisingly, the shares of MMM fell close to 6% upon the announcement.

These are two very large, global companies that are clearly looking through different lenses. As an investor it is important to know what to make of this seemingly contradictory and conflicting information. The simple answer, from Cove Street’s perspective, is that for a multitude of reasons people should take any single company’s assessment of the state of the global economy with a grain of salt. First off, depending on where we are in the economic cycle, certain companies may be benefiting (late cyclicals) while others are starting to struggle (early cyclicals). Second, as we learned in 2008, many companies and investors truly believed that the global economy was in fine shape until, of course, it quickly ground to a halt. Specifically, it has become quite obvious to us that CEOs have almost no predictive ability regarding near-term economic trends; if they did possess such skills they would make their lives easier and become professional money managers. Finally, we never know if companies themselves are seeing conflicting evidence in different regions and markets and are only focusing on the positives in order to keep their employees motivated. The point is that companies may have an incentive to paint a slightly rosier picture than is warranted for any number of reasons, including keeping stock prices from falling.

Expanding on that theme, it is the topic of incentives that leads me to the focus of this piece. After recently scrutinizing the questions asked by the sell-side analysts who are the main participants of the Q&A sessions held during company conference calls, it struck me just how different my questions would be from many of the ones asked. With all due respect to my brethren on the sell-side, it is shocking to see how much of company management teams’ time is taken up by questions that serve no other purpose than to help the analysts forecast the next quarter’s earnings. Instead of posing questions regarding the factors that will drive the long-term value of a company, on just about every conference call the executives are interrogated about income statement and balance sheet minutia that is only useful if you care about predicting short-term earnings to the exact penny. An outsider (like myself) listening to the calls can almost picture the analysts scrambling to adjust their fancy models on the fly.

Unfortunately, when it comes to the companies that reside in Cove Street’s portfolio, next quarter’s and even next year’s earnings are not the main determinants of our estimate of intrinsic value. In fact, our focus is primarily on activities that create sustainable free cash flow—a number that can be completely divorced from earnings per share—when we sit down to value a company. This disconnect is key. While we would ideally seek more clarity on a company’s capital allocation plans and secular headwinds and tailwinds, many sell-side analysts are incentivized to gather information on near-term earnings per share above all else.

If you sit back and think about how sell-side analysts receive notoriety, some of the reasons for this myopia become clear. The truth is that the financial media doesn’t focus at all on the important internal roles that analyst play—assisting with client service and investment banking. Instead, the majority of what we hear about is an analyst’s earnings forecast and his or her rating on a particular stock. Further, more often than not, the buy/sell/hold rating placed on a stock is based on some multiple of the analyst’s forecasted earnings for the next year. Therefore, the two things that analysts get most recognized for both have to do with their ability to accurately assess earnings prospects. Hence the importance of being able to guess next quarter’s depreciation expense number…

I was always under the impression that analysts were compensated based on the accuracy of their earnings forecasts and the performance of the stocks they recommended. Accordingly, I was shocked to see the results of a 2008 study by three gentlemen from Harvard Business School that found “no evidence that earnings forecast accuracy and stock recommendation performance are directly related to analysts’ compensation.” Instead, the authors determined that sell-side analysts were compensated based on how they were rated by buy-side investors (as reflected in Institutional Investor rankings), covering a company that does business with the investment bank and following stocks with high trading volume. While that all may be true—and a little bit scary if you are a reader of sell-side research—I still believe that the financial press and the analysts themselves measure success based on forecasting prowess and the ability to identify the next hot stock. Thus, there is no reason to believe that the (somewhat absurd from our perspective) quarterly earnings game will not continue in the future.

The silver lining behind this myopic behavior is that long-term oriented value investors can benefit from the shortsightedness of others. It is still true that sell-side analysts can move stocks and markets. It is not rare to see a stock trading down on a day when the broader market is up because an analyst has cut his or her earnings estimate or rating on a stock. Oftentimes that downgrade is accompanied by phrases such as “lack of earnings visibility” or “near-term earnings growth is likely to remain subdued.” For a contrarian investor, statements like those represent tell-tale signs that the person in question is only concerned with proximate factors and establishing some kind of certainty in his or her forecasts. However, it is precisely during uncertain times when contrarian investors have the opportunity to buy assets at significant discounts to the present value of the stream of cash flows they will eventually generate. In other words, when many others are trying to determine whether a company will make $1.20 or $1.30 per share in 2012, we will continue to invest based on the long-term fundamentals of the companies we evaluate.

So, when you hear one of us (mainly Jeff) asking questions on a conference call, you better believe it won’t have anything to do with how much marketing spending is going to increase next quarter.

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