The trend in results vs. expectations.... going down.

If you have been paying attention or read many financial blogs (such as I do, too many to be exact), you would have seen commentators discussing the quality of earnings. Specifically, these commentators discuss the number of companies beating earnings expectations (expectations that were no doubt reduced throughout the second quarter) are roughly inline to slightly lower than the historic average. This compares to sales results that generally below expectations, calling into question how robust second quarter earnings results..  For instance, here is one story from The Big Picture blog.

Most of these commentators have focused on the companies in the S&P 500. As my investable universe is broader than just those 500 names, I thought I would expand the analysis to include the Russell 3000 index to see if the same dynamic is present across the investable universe. The graphical presentation is shown below.

The first chart above shows the last 12 quarters of the net percentage of companies that have beat earnings expectations in the Russell 3000, with net being the difference between companies that beat earnings expectations and those that missed expectations.. In the third quarter of 2009, a net percentage of 50% of the companies reported earnings that were ahead of expectations.  This compares to just over 30% currently. This trend has also been steadily in decline. I think this is worrisome, especially considering that both profit margins and profit margin expectations are running near historic highs. In addition, the net number of companies reporting sales results ahead of expectations is a negative 15%. The lowest amount in the last 12 quarters.

Provided this broad universe of stocks, I also thought it may informative to look at the trend by market cap.I broke the Russell 3000 into two groups, a large-cap group consisting of companies with market values over $2 billion and a small-cap group consisting of companies with market values below $2 billion. The graphs for these groups are below.

Large-Cap

Small Cap

Looking at the trend in earnings and sales results over the last 12 quarters for these groups, the trend in net sales and earnings in both the large-cap and small-cap stocks are similar. However, the degree of the downside in sales was more concentrated in large-cap company results. This is versus earnings results, where large-cap companies experienced higher net positive earnings surprises. In my opinion, this is likely due to large-caps having more "levers" to make quarterly earning results.

One last note before concluding this brief analysis (for now, as I think it is ripe for further research). I thought it may be informative to look at earnings growth versus the net percentage of companies beating or falling behind earnings and sales expectations. Specifically, I wanted to see the annualized growth in the trailing twelve months of EPS on a forward basis. So, for instance, the net percentage of companies beating EPS in Q4 2011 was just below 30%, and this is compared to the 7% trailing twelve month annualized growth in earnings in Q1 2012 vs. Q4 2011. I believe the trend is fairly apparent.




Although the trend, to the eye, may appear robust, it is also informative to see what the math sates. Statistically, the net number of companies beating expectations explains roughly 30% of the variance in the forward earnings growth and the results are statistically significant at about the 10% level. As for earnings expectations, about 45% of the variance in forward earnings growth can be explained by the number of net companies beating earnings expectations. This variable is statistically significant at the less than the 5% level. I plan on doing some further research to see if there is some tradeable information here, and if there is to what degree.