When the Securities and Exchange Commission (SEC) adopted Regulation Fair Disclosure (Reg FD) in 2000, the primary purpose was to even the playing field so that no investor had an unfair information advantage. The rule was “designed to promote the full and fair disclosure of information by issuers.”1 Out of that regulation came a more formal quarterly earnings call, part of a three-step recommended process for companies to comply with Reg FD.2
Leveling the playing field through the fair and complete distribution of material public company information is critical so that one investor—say a Wall Street firm—doesn’t necessarily get an information advantage over another firm—say one headquartered in Alexandria, Virginia—or an individual investor that lives in Spokane, Washington! So, a company can broadcast updates about the business in a fair and compliant way in these regularly scheduled earnings calls.
The end of a quarter (or the fiscal year) is a busy time for companies and investors. Companies usually release a package of stuff investors need to weed through, including a press release detailing key happenings and updated financial statements, then hold a call to discuss the results. And while Reg FD forces companies to disseminate information in a controlled manner, they don't mind because, naturally, companies want to control their narrative and spread the news that may affect their stock price.
Earnings calls typically follow a similar format:
As we mentioned, many companies like to control the narrative and tell a flattering story about what went well. That’s not necessarily bad!
But as investors, you have to be mindful of whether what the company wants to talk about at that moment, or what the analysts on the call are asking about, is relevant to what you think is going to drive the future value of the business and why you own the stock. So, one of the ways to decipher what’s important about the story they want to tell or the questions analysts ask is to go into the call knowing what you are looking for.
Let’s take a step back and talk about the Q&A portion. You have to be an insider to ask a question on these calls. So, it is challenging, but not impossible, for the “Joe Schmoes” (i.e., the everyday investor) or a small boutique investment firm to get their questions asked. Sell-side research analysts ask 95% or more of questions, and the motives behind their questions may not align with yours.
Effectively, the sell-side analyst’s job is to help their clients understand the business and guess if the security will outperform or underperform in the near term. For example, when an analyst publishes a target price, it’s usually for one year or less. So their goal is to understand the market’s expectations and attempt to ferret out where there will be near-term surprises on the upside or downside.
But that may differ from what a long-term investor seeks from the earnings call. So there are different aims, and hence the different lines of questioning that investors find useful.
As long-term investors, we look at something other than the potential return on investment for the next six months or one year. Instead, we’re trying to determine what a company can look like five or 10 years from now. So how do we do this?
We create a thesis on why we own the business and think it's an attractive investment. We also have a hypothesis, which theorizes what we expect to happen in the future. This hypothesis is our view of the world and the future.
Earnings calls help us compare what we think will happen to what is actually happening because we need to think about the investment correctly, appreciate the risks, and understand what the company is worth. Otherwise, we should not own it.
When we listen to calls, we're trying to wade through the short-term and hindsight information and data to find the three or four nuggets we need to follow to determine if our thesis is on the right path. So we go into a call with those metrics or questions we want to track to help us distinguish between signal and noise.
For example, while we keep an ear out for honest assessments of what went down in the past quarter and expectations for the next one or two quarters, we’re holding out for more useful context. We want to know how the company thinks about building its business, serving its clients, and creating value in the years ahead.
We just discussed the difference between the short-term and past information that many calls focus on and the long-term investment thesis we take. This is important because a stock may experience volatile trading on an earnings release or during a quarterly call. This is often short-term noise to us, but other investors worry that they're missing something. For example, we often hear questions about why a stock’s price dropped when earnings appeared “good.”
There are numerous reasons for this market action. But often, there are expectations—the amalgamation of outlooks from all types of shareholders, such as long-term investors and short-term traders—built into the price of a stock. Normally these types of moves are driven by that marginal short-term shareholder who has a very brief investment horizon and is trying to incorporate real-time information into the share price or capture a minuscule market inefficiency.
For example, a company grew earnings and cash flow by 18%, but the sell-side analysts had modeled a growth rate of 19% (the “expectation”). So now the headline reads that company missed earnings. Unfortunately, with the widespread use of trading algorithms and social media platforms, that "miss" is pronounced far and wide and interpreted as deteriorating fundamentals that may trigger a sell order.
But the headline does not capture the reason for that miss. For example, the company may be getting a great return on its marketing spend and decided to step on the gas and spend more on the program in the quarter. As a result, its earnings and cash flow may have taken a slight hit, but both could double nine months from now. For short-term investors, though, a nine-month payback might be too far into the future. But for long-term investors, this return aligns with their expected future growth.
Zoom Video Communications' (ZM)* stock price fell slightly after its recent quarterly call, even though the company beat earnings estimates and raised its forecasts. According to some reports, analysts are worried about the growth of its enterprise business.3 That may be a valid concern, but the analysts’ questions failed to address that worry. According to Bloomberg, almost half of the first 16 questions asked about artificial intelligence (AI). Only one analyst asked about the enterprise segment.4
We’re not opining on the state of Zoom’s business or the importance of AI, but if enterprise growth is the primary concern holding the stock down (as the media says it is), shouldn’t that be the focus of the analysts’ questions?