Earnings quality and the art of asking the right questions

I was going through some of some old links on my reader along with some unposted blog posts and came across this article. The article, from alephblog.com, brings up a really great point when it comes to earnings versus estimates.... always question the earnings results and why the company achieved what it did. What are the quality of earnings, what are the quality of the company's accounting metrics, is the miss or beat temporary, etc.

Missing Earnings Estimates

Missing earnings estimates hurts in the short run, but it doesn’t mean much if there is no indication that the overall earnings trend has changed.  If the overall trend in earnings has turned down watch out.  Prices can fall as for Zynga and Facebook.
Then you have something like Reinsurance Group of America [RGA].  It recently missed earnings by 12 cents. $1.77 expected, $1.65 actual.  You should want your companies to miss estimates every now and then.  It raises the probability that the accounting is honest.  With a company like RGA, earnings comes down to how many/few large value life insurance policy deaths they have in a quarter.  You are subject to the “law of small numbers” even with the second largest life reinsurance block in the world, because it is the big policies that matter.
Even this does not qualify as a bad quarter for RGA.  Can’t remember a time when they lost money, but they have missed by far more.  Often I have bought shares on such a day; I did not get any on the brief lousy open after the earnings announcement.
With RGA, I hope the price goes down.  I will buy more.  Why?

• It rarely misses earnings.  The company is conservative with guidance, and usually beats.  Cumulatively, over 2 years it always beats.
• Life Reinsurance is an oligopoly.  It is one of the less competitive areas of the insurance industry.
• It is valued at less than 8x current earnings, which are expected to grow, and less than book value, and even book value less AOCI.
• You have actuaries running the place.  Actuaries have an ethics code.  I’ve met the management; talked with them on the phone.  Occasionally been on their conference calls.  They seem honest and competent.  I have worked for dishonest and/or incompetent insurance management teams occasionally.  I know what they feel like.  One thing dishonest insurers do is always make earnings by shorting reserves, and then, when the reserving imbalance is too great, deliver a lollapalooza of a bad quarter which more than erases the seeming excess earnings.

That RGA would deliver a slight miss is encouraging to me.  The accounting is honest.  RGA is the #2 or #1 firm globally in what it does.  Unlike the deceased Scottish Re, it was conservative in M&A.  It let Scottish Re overpay for deals, while it sat back and saw an undercapitalized competitor cobble together a life reinsurance block nearly as large, but one that was unprofitable, because of the high prices paid to get it, and the opaque holding company structure (worthy of AIG in miniature).
More generally, when a company misses earnings:

• Does it revise current guidance?  If it doesn’t it may be temporary, and a fluke of accounting rules.  Look at the accruals to give you a clue.
• How are industry dynamics?  If everyone is missing estimates, there is a reason to mark future prospects down.
• Analyze where companies in similar industries have been taken private.  That serves as a ground floor for where valuations could go.

And with that, I leave you with RGA.  I have argued for years that Buffett should buy it.  Excellent company, does not need guidance.  Could take over his inferior #5 position in life reinsurance which has lost money and become #1 … and then the life reinsurance industry will have no more pure plays.  Kind of sad, but logical, because larger P&C reinsurers benefit from the diversification.
So RGA missed earnings.  Who cares?  A little lower and I load the boat.