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.

 


 

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

Australian house prices close in on world record

Sydney is set to become the world’s most expensive city for housing over the next 12 months, a new report shows. Our other major cities aren’t far behind unless there are major changes to improve housing affordability.

The case for the $3 million super tax

The Government's proposed tax has copped a lot of flack though I think it's a reasonable approach to improve the long-term sustainability of superannuation and the retirement income system. Here’s why.

7 examples of how the new super tax will be calculated

You've no doubt heard about Division 296. These case studies show what people at various levels above the $3 million threshold might need to pay the ATO, with examples ranging from under $500 to more than $35,000.

The revolt against Baby Boomer wealth

The $3m super tax could be put down to the Government needing money and the wealthy being easy targets. It’s deeper than that though and this looks at the factors behind the policy and why more taxes on the wealthy are coming.

Meg on SMSFs: Withdrawing assets ahead of the $3m super tax

The super tax has caused an almighty scuffle, but for SMSFs impacted by the proposed tax, a big question remains: what should they do now? Here are ideas for those wanting to withdraw money from their SMSF.

The super tax and the defined benefits scandal

Australia's superannuation inequities date back to poor decisions made by Parliament two decades ago. If super for the wealthy needs resetting, so too does the defined benefits schemes for our public servants.

Latest Updates

Planning

Will young Australians be better off than their parents?

For much of Australia’s history, each new generation has been better off than the last: better jobs and incomes as well as improved living standards. A new report assesses whether this time may be different.

Superannuation

The rubbery numbers behind super tax concessions

In selling the super tax, Labor has repeated Treasury claims of there being $50 billion in super tax concessions annually, mostly flowing to high-income earners. This figure is vastly overstated.

Investment strategies

A steady road to getting rich

The latest lists of Australia’s wealthiest individuals show that while overall wealth has continued to rise, gains by individuals haven't been uniform. Many might have been better off adopting a simpler investment strategy.

Economy

Would a corporate tax cut boost productivity in Australia?

As inflation eases, the Albanese government is switching its focus to lifting Australia’s sluggish productivity. Can corporate tax cuts reboot growth - or are we chasing a theory that doesn’t quite work here?

Are V-shaped market recoveries becoming more frequent?

April’s sharp rebound may feel familiar, but are V-shaped recoveries really more common in the post-COVID world? A look at market history suggests otherwise and hints that a common bias might be skewing perceptions.

Investment strategies

Asset allocation in a world of riskier developed markets

Old distinctions between developed and emerging market bonds no longer hold true. At a time where true diversification matters more than ever, this has big ramifications for the way that portfolios should be constructed.

Investment strategies

Top 5 investment reads

As the July school holiday break nears, here are some investment classics to put onto your reading list. The books offer lessons in investment strategy, financial disasters, and mergers and acquisitions.

Sponsors

Alliances

© 2025 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.