Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 251

Three checks to make when facing earnings downgrades

“The market doesn’t care how you feel about a stock or what price you paid for it.” – Howard Marks

Most stock market participants are required to deal with earnings downgrades from time to time: they can hurt, or they can be a fantastic buying opportunity. When a downgrade occurs in a company within our investment universe, we follow a checklist. If we can comfortably answer yes to each item, it helps rationalise our thought process. If supported by a foundation of quantitative and qualitative analysis of the company, industry, and competitors, there may be an opportunity to either enter a new position or add to an existing holding. If not, we are unlikely to invest or may reduce or exit an existing position.

The three items to check are:

1. Has management been consistent in their rhetoric?

“There’s a big difference between probability and outcome. Probable things fail to happen—and improbable things happen—all the time.” - Howard Marks

From our experience, a high-quality management team is the biggest factor to consider when investing in small companies. We meet with management teams on a regular basis, and over time, we gain an understanding of actions versus words. Management rhetoric – whether it is consistently good or consistently bad - is a key factor. We would prefer a management team deliver downbeat news consistently rather than being too hopeful and incorrect. The market tends to look through poor divisions or issues if they can be siloed from the rest of the business, or if the issues are short term in nature. The market is much less forgiving on failed hype.

A recent example is BSA (ASX:BSA), a telecommunications and engineering services business. Its HVAC construction operation has been consistently underperforming. It is a competitive market sector and there does not appear to be significant improvement on the horizon. However, management has been consistently upfront with investors about the health of this division which is dragging heavily on earnings. Ongoing poor results with no unexpected negative surprises make it easy to ‘look through’ and focus on what is going well in the rest of the business, namely its unique exposure to the maintenance of the NBN which is beginning to contribute to company earnings.

2. Has there been a change in strategy?

“To be an investor you must be a believer in a better tomorrow.” - Benjamin Graham

In our view, investing in small companies requires a long-term investment horizon (three years+). Internally we have a minimum hurdle rate of 20% p.a. return over a three-year period when assessing a company to invest in. Taking a long-term view means we are ‘buying into’ a strategy set by a company’s board and management team. It is difficult for a business to perform to expectations all the time, however if the strategy remains on course then we are likely to be more tolerant of downgrades.

If there is a sudden change of direction from the previous strategy, then this is a concern. This should not be confused with pragmatic management, which we would define as being flexible within an overarching plan, as opposed to a change of plan itself. An unexpected change in strategy can often indicate a shift from acting in the best interest of shareholders, to the board and management focusing on their own interests.

For example, during 2015, CML Group (ASX:CGR), an invoice financing business, experienced unexpected losses due to outstanding construction loans. The loans were unrecoverable and caused a large P&L hit at the time. Management made it clear that the construction industry was not part of their strategy for growth and it should diminish as an exposure over time. We felt the overall business strategy had not changed.

3. Would I buy it lower?

“Unless you can watch your stock holding decline by 50% without becoming panic stricken, you should not be in the stock market.” - Warren Buffett

Sell-side analysts will typically release their updated (or downgraded) reports within 24 hours of a result. This can mean you see a further decline in stock price after the fact, as bearish medium-term outlooks are often applied by analysts. The inverse usually happens following a positive announcement. Oversold and overbought stocks are most likely to exist at this point in time.

If the information released to the market causing the downgrade doesn’t impact your original investment thesis, then your margin of safety has improved, potentially dramatically. Despite the short-term facts changing, you should ask yourself ‘does this change my two- or three-year target price?’ Furthermore, if the share price continues to decline ‘would I be again happy to buy at lower prices’? If we can answer these questions with confidence, then this will contribute to our decision to either enter or exit a position.

The overall message is not to view every earnings downgrade as a negative. If we can become comfortable with these three key checklist items, we believe opportunities can present themselves which may not seem so obvious to other market participants.

 

Robert Miller is a Portfolio Manager at NAOS Asset Management, a boutique funds manager investing in emerging and small-mid cap industrial companies. This content has been prepared without taking account of the objectives, financial situation, or needs of any individual.

 

  •   3 May 2018
  •      
  •   

 

Leave a Comment:

RELATED ARTICLES

Is FOMO overruling investment basics?

Feel the fear and buy anyway

Australia: Most listed stocks per capita and biggest gamblers in the world

banner

Most viewed in recent weeks

Are you making these SMSF mistakes?

After four decades advising investors, there are a few common mistakes I've seen SMSF investors make. From holding too much cash and chasing yield to overtrading and trusting tips. Are these errors costing you?

Why have Australian living standards 'fallen' and how do we fix it?

For the last few years there has been much talk of a 'cost-of-living' crisis in Australia and of 'falling living standards'. Lately this has flared up again with the pickup in inflation resulting in a renewed fall in real wages.

Retirement spending is not one-size-fits-all

New data challenges the idea that Australians are underspending their super. The bigger issue may be helping retirees navigate complexity, make confident decisions and use their savings to support security, wellbeing and choice.

Will you run out of money in retirement?

Fear of running out has become a defining retirement anxiety. Why do some retirees die with substantial wealth while others deplete their nest egg? Evidence suggests the answer is more complicated than we think. 

Four options for an income investor’s next dollar

What if Australia’s golden age of dividends is ending? Rather than overhaul your portfolio, it may be worth considering where new capital can work harder. I discuss four income strategies and the trade-offs behind each.

The missing link in the CGT debate

A little-noticed consequence of Labor’s tax changes could have implications well beyond investors’ tax bills. The issue raises bigger questions about incentives, capital allocation and the drivers of long-term economic growth.

Latest Updates

SMSF strategies

Meg on SMSFs: What do we think about reversionary pensions these days?

Reversionary pensions have long been a staple of SMSF estate planning, but are they still the best option? Meg Heffron revisits a once-clear favourite and asks whether changing super rules have shifted the balance.

The ageing ‘crisis’ has not and will not happen

Rising age dependency is frequently treated as a warning sign for economies. But when actual workforce participation is examined, a strikingly different picture emerges about ageing, productivity and economic sustainability.

Retirement

How does the 4% rule stack up?

The 4% rule has long been retirement's gold standard. But after a difficult period for investors, fresh analysis suggests a more conservative approach may significantly improve the chances of making savings last.

Shares

Four charts that expose market concentration risk

Investors have recently been rewarded for backing market leaders, but history suggests this eventually comes at a cost. Now may be the time to review whether your portfolio is carrying unintended risks beneath the surface.

Investment strategies

The case for gearing beyond property

Most Australians gear into property but ignore shares. That may be a mistake. Used carefully, geared equity strategies can enhance long-term returns, reduce cash tied up in growth assets and support retirement income goals.

Economy

Australia's $1 trillion debt pile

The headlines exclaiming that Australian government debt has hit A$1 trillion and US government debt has hit $40 trillion has turned heads, but how serious are they really? Will Australia's mix of debt create challenges?

Economy

Has 100 years of growth made us any happier?

For decades, GDP has been the benchmark for economic success, but has it made us materially happier? If happiness does not rise in lockstep with prosperity, are we overlooking what constitutes a successful society?

Sponsors

Alliances

  • ASA-Logo-RGB-ActiveGreen-web.png

© 2026 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. To the extent any content is general advice, it has been prepared for clients of Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), without reference to your financial objectives, situation or needs. For more information refer to our Financial Services Guide. You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.