Whether or not quarterly earnings meet consensus expectations is central to the Share Price Game. Because quarterly earnings has become the most important measure in determining stock price, meeting quarterly earnings targets implies that a company is meeting its publicly stated overall growth targets and will continue to do so. Conversely, missing quarterly earnings targets, even by a few cents per share, has dire implications for a company.
Sometimes earnings growth cannot be maintained in the short run until additional reserves can be established or the macroeconomic environment improves. When this happens, executives can resort to managing investors’ expectations of long-term growth. They do this by lowering forecasted quarterly earnings estimates through “whisper numbers” communicated to analysts. Then they exceed these lowered estimates and declare that the company did better than expected. Thus they not only maintain long-term expectations of sustained growth but also reinforce the infallibility of management to deliver on its promises.
Investors understand, at some level at least, that executives are playing the Share Price Game and that the company will do virtually anything to avoid missing the consensus forecast. A miss would imply that management had no other possible way to maintain the appearance of growth on schedule. The amazing thing about the Share Price Game is that investors know they are participants in it but remain addicted.
The Greater Fool Theory
When investors are told to expect high historical growth rates to continue indefinitely and to consider the risk of lower growth to be minimal, the Greater Fool Theory of investing replaces a more reasoned approach. One investor counts on another investor to pay a higher price for the stock based on future expectation of higher profits, sustained growth, and low perceived risk. An investor makes money off a stock in two ways: from dividends and from appreciation of the stock price. The price of a stock ultimately depends on the stream of future dividends that the stock will pay. But as the dividend yield (dividend amount relative to stock price) decreases, the appreciated value at which investors expect to sell the stock at a future date contributes a larger portion of the expected investment return and therefore drives current stock price. In the case where stocks pay no dividends, this estimated appreciation comprises the total return. When shareholders are not taking money off the table in the form of dividends, they remain wholly dependent on the relationship between the buy and sell price for their return.
One can look at these two profit components and how they are affected by the Greater Fool Theory in two different scenarios.
Investing Scenario #1
The assumption behind this first scenario is that both the buy price and the sell price of stocks accurately reflect real sustainable value based on full disclosure and full understanding by all investors. Stock price appreciates, therefore, as a result of real growth, real productivity enhancement, and real risk return assessment. This means that as fundamental value increases or decreases, stock price generally follows suit. A lack of dividends is acceptable to investors under this model because the likelihood of catastrophic events is low. It breaks down when stock price does not reflect real value.
Scenario #1 depends, of course, on something called efficient market theory. Throughout the 1970s and 1980s, prestigious U.S. colleges and universities taught that improved communication ensured that all relevant “facts” were known to a sufficient number of market participants, that the market adjusted almost simultaneously, and that stock prices reflected “truth” with regard to real value.
Professional traders and investors never fully bought into this idealistic view. They knew that they could beat the market not only by doing better analysis, but also by gaining access to better information or by correctly assessing the temporary influence of investor emotions. These same groups, however, generally agreed that in the absence of systematic nondisclosure or misleading information, the capital allocation system functioned reasonably well.
Investing Scenario #2
The second scenario says that neither the buy price nor the sell price must accurately reflect real value. As long as the perception of growth is maintained and risk is minimized, the share price will rise. This model is predicated on a lack of full disclosure and depends on earnings management and a healthy dose of spin control. Investors rely on rising stock price instead of dividends to create investment returns.
From the investors’ viewpoint this model breaks down when an unpredictable event occurs and the sell price suddenly moves to reflect the stock’s long-term, sustainable value. This price may be substantially lower than an investor’s buy price once the market loses confidence in management. Shocks like this take place when previously reported earnings have not been accurate, which means that assumed growth rates have also been skewed. They can also happen when previously undisclosed risks come to light, causing investors to increase their assumed discount rate.
How Stock Price Is Affected
The pattern of stock price movement varies significantly between these two models of capital allocation. In the first model, as a company grows rapidly and risk is controlled, its stock price will trend higher as strategy and execution convert opportunity to earning power, and more important, as confidence in the trend continues. The rise in stock price will not be a straight line. Investors will assess information and recognize new risks and opportunities that may affect the company’s ability to pay future dividends. If management fails to reinvest and sustain growth from existing or new activities, the stock price may stop rising or even trend lower for long periods and possibly decline to zero. Some level of short-term volatility will certainly occur, but as all investors react to developments, dramatic swings in stock price will only result from real changes in opportunity or risk.
In the second model, as long as the perception of steady growth and minimal risk can be maintained to attract a Greater Fool, stock price generally will rise. Certainly there will be bumps, but to the extent that new risks are obfuscated and the perception of earnings growth is maintained, even when real growth does not occur, the rise may occur relatively steadily. The longer perception differs from reality and new Greater Fools enter the market, the more the stock price deviates from reality and the greater the correction will be when investors learn the truth.
A Practical Example
Graphically illustrates the effects of the two models. In the case of Company A, stock price has not been managed. Although Company A is hypothetical, the stock price charts of many companies appear similar to the one shown. Using the price chart of a real company would have made a more powerful statement, but determining with certainty that stock price has not been managed is significantly more difficult than determining that it has. (In addition, few, if any, companies today would want to hold themselves up as a public example of purity.)
The second company shown in the exhibit is real: Tyco International. While Tyco has avoided bankruptcy, it personified earnings management and obfuscation abetted by a board that failed to notice what was going on until Tyco’s businesses were unmasked as a group of average growth companies with little in common. CEO Dennis Kozlowski has been charged with fourteen counts of sales tax evasion as well as corruption, conspiracy, grand larceny, and falsification of records.
One could logically conclude from the two charts that those who owned shares in Company A are undoubtedly a lot happier today than those who invested in Tyco. While prices were rising, investors understandably might have favored Tyco. But the end is always the same when earnings are managed and perceptions of risk are minimized. John Bogle, the founder and former CEO of The Vanguard Group, summed up this inevitability succinctly: “The fact is that when the perception (interim stock prices) vastly departs from the reality (intrinsic corporate values), the gap can only be reconciled in favor of reality.”