Biases in analysing company reports

The company results season keeps analysts busy, with an avalanche of information.  Indeed, more numbers are delivered than realistically can be analysed.  Behavioural finance tells us that it is human to make mistakes in understanding all this data – but how can investors get the most out of all this company news?

 The problem is not merely that analysts cannot process every last detail that emerges.  Companies themselves understand the challenge, and know this means that some facts can effectively be hidden.  Company management can present results in a way that conforms legally, but makes misunderstanding the true position more likely.  Unsurprisingly, any mistakes are usually in companies’ favour.

 In a short space of time, companies deliver preliminary results, report and accounts and an AGM statement.  Analysts tend to write their recommendations based on the first of these, and rarely are separate research notes written on publication of accounts.  Yet, there may be important differences between the two; prelims offer greater flexibility to accentuate adjusted earnings and other favourable numbers selected by management.  When the annual report eventually follows, the emphasis may have shifted subtly. 

 Indeed, companies can create their own metrics.  Ratios can be plucked from the air to find something positive in an otherwise disappointing year.  Some select measures like future contract value or margins excluding specific costs.  Few investors question what these figures actually mean.   And, surprisingly, even conventional measures like order books and same store sales lack a standard definition, and may not be audited.  All this extraneous data can easily divert analysts from focusing on figures that are comparable across time periods or throughout the industry.  What the apparent additional detail does is help to build up a picture that expectations have been met, even if the numbers are not the precise ones the market was expecting.  We are attracted to stories, and tend to connect up and find meaning in detail even when we should not.

 Investment analysts, like most experts, can be influenced by confirmation bias.  We tend to pick out what suits us.  Additional and even irrelevant evidence can be misread as additional support for an initial view.  With so much extraneous data presented upfront, it is difficult to conduct a systematic analysis of company results.  And, hindsight bias can encourage analysts to believe their results forecasts have been met.  Companies may adjust earnings to encourage this misunderstanding; the truth may only become clear when the accounts are published.

 Undoubtedly, many companies spend a great deal of time crafting their statements.  Analysts need to cut through this verbiage.  Often there are subtle differences between preliminary announcements, accounts and an AGM statement that may more truly indicate recent trading.  By the AGM, the language of a business outlook comment can suddenly include new words like “overall” or “broadly”.  A business that was meant to be recovering might move to an “overall improvement” that subtly points to new problems.  Trading that is “broadly in line with consensus” is rarely on target to beat forecasts.  Indeed, “broadly” usually means worse, and analysts need to interpret just how much of a shortfall “broadly flat” might mean. 

 Analysts accustomed to writing their research reports based on prelims, should look hard at the annual reports now arriving.  And, as we enter the peak period for AGMs, investors need to examine the language of trading updates.  Recognising the behavioural issues involved is the first step to better company analysis.