What Value Investors Look for in Quarterly Earnings Reports

Well we're just about nearing the end of the reporting season for quarter 3, 2007, and I thought it might be an opportune time to briefly discuss quarterly earnings announcements - and what Value Investors generally look for.

True - Value Investors do not focus or judge companies on quarterly earnings performance, but rather assess a company on its performance during different parts of the long term business cycle. This however, does not mean that Value Investors do not pay attention to quarterly earnings reports.

Quarterly earnngs reports allows Value Investors to extract 2 qualitative dimensions about a company and the industry it operates in:

(i) Quality of Management - Is Management shareholder-oriented? Is it open, candid and honest in the manner it reports and answers questions?

(ii) Industry Changes - what's going on in the industry? Have any fundamental changes occurred?

I have always found Morningstar's research and website a great investing resource. (At the right price, Morningstar Inc (Ticker: MORN) would be definitely worth looking at). Anyway, I came across the following 3 minute video by Pat Dorsey, Director of Stock Analysis at Morningstar.

If you've got a few moments, have a look at the video below. If you like what Dorsey has to say, I highly recommend his The Five Rules for Successful Stock Investing - it's a great book for a Value Investor that is just starting out.

Below is a brief summary of the tips that Dorsey provides, as well as a few insights and recommended resources of my own.

Earnings News or Earnings Noise, July 2007

(1) Don't focus on the the quarterly earnings number - it is the least relevant. If there is only one thing you should take away from Dorsey's advice it is this:

(2) Ignore the Headlines - face the facts - it is only natural that companies will 'put their best foot forward' and report in a manner that optimizes how they look. Most public companies hire PR / IR consultants whose job it is to frame them in the best light. So the challenge before Value Investors is to cut through the PR jive and get through to the nitty gritty.

(3) Focus on Why, Not What - Revenues are dropping? Margins are eroding? Inventories are building up? You've got to be asking yourself 'Why?'. Why is this happening? Is this a new trend? Has something changed in the industry? The answers to the "Why' question are usually what alerts Value Investors to significant changes in the industry. (To see why this is high importance take a look at this).

(4) What Do You Want To Know - Before the earnings release, Dorsey recommends that investors should make a list of what they want to know from the earnings release. I totally agree. By taking this step, you move from being in 'passive mode' where the company information is 'dressed up' and 'fed to you', to 'active mode' - where you in control of what you seek. It is a good sign when a company is able to answer all your pre-prepared questions. It means that they are being upfront and candid with investors, telling it exactly as it is.

(5) Listen to the Conference Call - There is so much qualitative information that can be gleaned from company conference calls that the importance of this tip cannot be understated. These days, almost all public companies in the US allow investors to listen in on the conference call via the internet or via phone. The investor relations section of the company's website will tell you how to do this. Generally, these calls are divided into 2 parts: a pre-prepared statement (which is usually read out by the CEO / COO /CFO), and then a Q&A section where industry analysts ask questions. It is the second half of the call that I find of greatest value to me. These analysts typically know the industries they cover like the back of their hands. It's their bread and butter. Remember - they are most probably covering the company's competitors as well - so they should be able to recognize shifts in industry trends. So pay special attention analysts' questions - they may raise some important red flags. Equally important is how the company's management answers analysts' questions. Are their answers open and candid ('yeah - we really messed up' or 'we really don't know') or are they defensive and evasive?

The following tip may be too much for some investors, but I also like to re-read the earnings transcript for the previous quarter. If you make a habit of taking notes, then you just re-read those notes. You should take note as to what extent the company's management is optimistic and upbeat.You should also note any forecasts of growth - even if they are somewhat vague. (you'll get used to the lingo - single-digit, double-digit, low teens, high-teens). By doing this you can then compare what they said last quarter to what they are saying now - and immediately identify any changes. An Israeli company that I have been watching closely and which is releasing it's Q3 earnings report tomorrow may provide a prime example. Stay tuned.

A Great Resource for Quarterly Earnings Transcripts: Check out Seeking Alpha.