Lowballing of projected earnings is a downer


AFTER DECADES of generous overoptimism about corporate profits, why are Wall Street stock analysts suddenly getting earnings projections badly wrong on the downside?

"That's one of the most interesting questions I've seen in a long time," says Rebecca McEnally, capital markets director for the CFA Institute, an association of financial analysts.

It's interesting because analyst projections play a key role in stock prices, because analyst caution has helped keep a lid on markets despite big earnings gains, and because the shift suggests something has changed in analyst behavior, the economy or both.

It also highlights continuing large profits and suggests stock prices may not fully reflect corporate America's earning power.

Usually analysts walk into the office on Jan. 2, publish rosy projections for the year and then repeatedly revise them downward as reality intrudes in the form of lower-than-expected quarterly profits and company "guidance," which is what drives earnings estimates anyway.

From 1979 through 2003, analyst expectations for annual profits in the S&P; 500 index declined 9.7 percent on average from the beginning of the year to their final, nearly precise estimates before fourth-quarter results came out, says Ed Yardeni, Oak Associates' chief economist.

In only two of those years - 1979 and 1988 - did analysts underestimate profits for the coming year. They did it again in 2004, with profit projections for the S&P; 500 rising 7.8 percent over the course of the year to conform with much stronger-than-expected results. S&P; 500 operating profits - the kind Yardeni follows, which exclude non-core results such as pension gains - rose a spectacular 23.7 percent last year.

No way would analysts be too conservative again this year, Yardeni figured. They had never lowballed corporate profits two years in a row.

But that's what seems to be happening. According to Thomson Financial, analysts began 2005 expecting S&P; 500 earnings to collectively increase 8 percent for the year compared with actual 2004 results. Now they're predicting 10.6 percent, and Yardeni believes actual earnings will rise by closer to 12 percent over those of 2004.

Why have analysts, once corporate America's greatest cheerleaders and flacks, gotten so diffident?

In part, Yardeni blames corporate executives for sandbagging analysts and investors with overly cautious profit guidance.

"For some reason, management feels compelled to curb everybody's enthusiasm," he says.

The reason, actually, isn't hard to identify.

As stock prices collapsed after 2000, managers who overpromised profits got their fannies sued off. Some went to jail for cooking books to achieve the aggressive projections. In a post-Enron world, with Sarbanes-Oxley laws requiring executives to certify reported profits, everybody wants to be cautious.

But executives aren't alone. Analysts are under pressure to be conservative also. Blamed along with management for delusions that caused the 1990s stock bubble, they too have motive to rein in their enthusiasm.

The rewards for the enthusiastic analyst who is correct have fallen, and the risks of being incorrect have risen.

"Even if they stick their neck out and get wildly bullish on a company and turn out to be right, they're not going to get paid that much," Yardeni says. "On the other hand, if they're wrong they're going to get fired."

Combine this with the new Regulation FD, for fair disclosure, which strictly prohibits executives from giving inside information to analysts on the sly, and you have a formula for less-informed, risk-averse stock experts. Combine that with continued strong consumer spending and continued corporate productivity gains via technology and downsizing, and you get continuing failure to forecast the full extent of the profit boom.

Note that analysts' traditional New Year's overoptimism on annual profits - a relatively long-term call - is different from their estimates of quarterly profits just before earnings are announced. For years companies have famously beat analysts' final estimates on quarterly results by a penny a share or two, surprising nobody but the CNBC commentators.

But even there, analysts have gotten more conservative, says John Butters, a research specialist at Thomson Financial. Through the decade ending in 2003, the year after Sarbanes-Oxley was passed, companies on average beat quarterly final estimates by 3 percent, he said. They've since been topping final estimates by about 4.5 percent.

McEnally, of the CFA Institute, believes analysts might also have been influenced by corporate whining about Sarbanes-Oxley compliance, which executives said would damage profits and which McEnally says is far overstated.

Analyst undershooting on profits is part of a wider pattern of disrespect for stocks. Even real, reported profits haven't boosted stock prices as much as they would have in the 1990s, which drives bulls such as Yardeni crazy.

Investors seem to be sinking money into housing these days, not equities. At 16 times projected yearly profits, the S&P; 500 is as cheap as it has been in years. And, we now know, there's a good chance those projections may be too low.

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