Over and under earning

One of the most useful issues that analysts can identify is when a company is over or under earning. Sometimes this leads to miss pricing in the market. When earnings move up or down by a large amount there is the chance that the market has trouble properly valuing these moves.

The volatility in earnings that the pandemic caused has been a good case study and continues to be so. We can clearly see that some companies over earnt during covid and that their multiples have tried to adjust for this. Ordinarily we would expect that for company that is over earning that it's multiple will be lower than average. On the flip side a company that is under earning should have a higher PE. Of course, estimating normalised earnings and a normalised PE is open to interpretation and estimation error that is where the skill and potential lie.

Despite these issues identifying and estimating over and under earning is an area ripe for potential alpha. Every now and then you may come across the company that is clearly underearning while also having a low PE as well as passing other quality filters. Having a longer time frame than the market opens an opportunity for value add.

On the back of this and slightly off the point, I have undertaken a broad analysis of a selection of US and Australian stocks to see if over earning during the pandemic is significant and therefore an issue going forward. The results I found surprising even admitting that is a limited universe of stocks of about 120.

There was a difference between the Australian and US experience as far as I could see. The Australian stocks, generally show little evidence of widespread over earning. i estimated this at about 1 to 3%. There are the obvious examples such as some retail stocks and some pathology stocks but outside of these not much impact.

The US was quite different. The over earning of the selection of stocks I looked at was much higher at about tender 10-13%. Not sure why maybe because the largesse in the US was much higher. The implications are that the US market is more vulnerable to earnings downgrades then the Australian market. The extent of over earning in the US was across many more sectors than Australia as well.

Obviously, this is a narrow measure but speaks to more turbulence if the Fed is determine to squeeze excess out of the system, especially in the US.