Legends of the Shortfall: Why So Many Firms Missed Estimates in 2000

We all know what it's like to be overly optimistic.

Take the bride who buys her wedding gown a size smaller because she anticipates losing weight before the big day. With the seams splitting as she walks down the aisle, how could she have predicted that cutting out the cookies would be her hardest obstacle yet?

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That must've been how companies felt as they continued to miss earnings estimates. But how could so many have been so wrong?

The New York Times addressed part of this question on Dec. 31, pointing the finger at analysts and their need to consistently dish out rosy company reports to ensure continued investment banking work.

While I agree analysts are part of the problem, we can't put all the blame on those folks.

"There are so many variables that can go into a company missing earnings that it's hard to generalize," says Howard Ward, manager of the (GABGX Quote)Gabelli Growth fund. What about the erratic economy? Or a management team that is overzealous in its forecasts?

Since earnings season is nigh, it's a good time to explore these other factors and search for lessons from the wreckage.

The Erratic Economy

Big Al Greenspan kept saying that the economy was growing at an unsustainable rate and, well, maybe he was right. No one else seemed to agree with him, though. "People were overly optimistic coming into this year with earnings growth," says Ward.

But in a continued effort to stop the economy from growing at this "unsustainable rate," Greenspan and his Federal Open Market Committee raised rates six times since June 1999. When rates are increased, borrowing and spending drop. In turn, so do sales. (Of course, the Fed reversed course and cut rates yesterday, but that will take some time to take hold on the economy.)

Simultaneously, though, the costs of raw material, wages and benefits soared thanks to a highly competitive job market. Combine these extra costs with a drop in revenue and things got ugly.

Just when the market hit its peak in March 2000, money was reverted elsewhere to pay high tax bills from big capital gains generated in 1999. Tax and withholding payments increased 11% from the prior year and one of every three dollars was being paid to Uncle Sam, says Charles Kadlec, chief investment strategist at Seligman Advisors and author of Dow 100,000: Fact or Fiction. No wonder spending slowed.

Throw in rising oil prices and you've got a serious economic mess on your hands. Remember, the U.S. is an importer of energy, so we had to spend more to get it. That means less spending elsewhere.

So the confluence of the Fed tightening, the increase in tax payments, rising energy prices, not to mention a weak euro, all hampered the economy.

This deterioration was happening all year long, "yet it wasn't until somewhere between October and November that the corporate world really noticed it," says Ashok Ahuja of Icor, a Westport, Conn., firm that operates a technology hedge fund. "It hit people by surprise."

But by that point it was too late.

Overzealous Management?

It was easy for management to get caught up in the tidal wave of exuberance. The market was on speed, and it wasn't going to stop for anyone or anything.

Companies project future results based on past performance. Management looks at what happened historically and hopes to meet that or do better. But CEOs were trying to grow their companies at unrealistic rates, says Ward. "It's one thing to say we're going to grow at 20%, but if 15% is a realistic number, there's nothing you can do about the 20% estimate."

"But they have to overshoot. They have to be optimistic by nature," says Ahuja. Companies have to predict that they're going to do better than last year or nobody would buy the stock. Many times, however, companies purposely low-ball their estimates so they can beat those numbers and watch their stock soar. But analysts know this game, so they bump estimates even higher than the company's projection. Now the number on the Street may be too much for the company to handle.

An additional problem is that by the time management discovers the makings of an economic slowdown, Wall Street already has received that quarter's earnings estimates. "Once expectations are in place, they're exceedingly difficult to correct without causing the stock price to take a nosedive," says Mike Young, Willkie Farr & Gallagher securities law and financial reporting partner and author of Accounting Irregularities and Financial Fraud.

But isn't that why companies spend so much money forecasting future earnings? Sure, but they didn't believe there would be a slowdown in consumption of products, so they got lackadaisical about forecasting and were unable to predict what people were going to buy, says Samuel Hayes, a finance professor at the Harvard Business School.

That lack of forecasting affects everyone on the supply chain. If you're a supplier to a major manufacturer, you look to those major companies for economic clues, says Hayes. "But if the company is not giving you any tips, it's like being on a highway with a big truck in front of you going 70 mph and you can't stop."

Of course, hindsight is always 20/20, but the Y2K market mess was a lesson in fortunetelling. "Frequently, insiders aren't any better at predicting their numbers then the rest of us are," reminds Young. Remember, earnings estimates are exactly that -- one big educated guess.

Lessons for Next Time

But if the pros can't get it right, how are you, the investor, supposed to figure it out?

Live by the golden rule: Know thy company.

While it's not the perfect system, be on the constant lookout for bad news. Scan stories on your company. Read good investigative columns by people like our very own Herb Greenberg, the kind of writer who spends his days looking for the truth behind the numbers and sometimes finds it before the company does.

Read press releases and track earnings announcements and warnings. Does your company have a history of missing earnings? Or is this a one-time deal because of an isolated incident? Do your homework.

Going forward, try not to get caught up in the noise, albeit momentum or disappointment. Set realistic expectations for yourselves and your portfolios.

And if you need to buy pants a size bigger, do it. It's better than walking around with a big wedgie all day.

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