Is Pessimism the Key to Stock Growth?

The stock market rally that Microsoft sparked by smashing through its first-quarter revenue and earnings targets had barely started to take hold when Microsoft CEO Steve Ballmer began telling audiences that the results were an aberration.

A change in how software licenses are sold accounted for the big boost to the company’s top and bottom lines, Ballmer explained, and sustaining it going forward seemed unlikely. Ballmer’s message was clear: Don’t expect a repeat performance.

As anyone who follows stocks can tell you, expectations are everything for investors, psychologically speaking. A company that falls shorts of projections often pays the price with investors, while a company that beats even lowered targets can see its shares move into the green.

With Ballmer’s dour outlook, Microsoft appeared to be trying to lower the bar for itself, or at least to avoid setting an unrealistically high target for its second fiscal quarter.

Wait and See

“By and large, the market reacts very positively to companies that meet or beat and harshly to those that fall short,” Morningstar.com stock analyst David Kathman told the E-Commerce Times. “It’s a natural reaction, at least initially.”

While the bigger picture often comes into focus a day or two after an earnings announcement, once analysts and reporters have had a chance to pick over the bones of a quarterly report, by then “a lot of people aren’t paying attention anymore,” Kathman said.

So why don’t companies simply downplay their results all the time, set easy-to-hit targets for themselves and reap the rewards?

It is not that simple. Just ask Microsoft.

Cautionary Tale

In June, the U.S. Securities and Exchange Commission (SEC) and Microsoft came to an agreement that settled a long-running investigation into whether Microsoft used cash reserves and other accounting moves to either downplay or overstate quarterly results.

Microsoft admitted no wrongdoing, but the company agreed to follow generally accepted accounting practices (GAAP) going forward. The message implied by the settlement seems to be that an accurate accounting — neither too high nor too low — is what the public deserves.

Watchdogs Growl

In addition, there are other reasons why companies cannot lean too heavily on the pessimism crutch to boost their shares. For starters, if stock analysts are doing their jobs correctly, they should catch on to the ploy and prevent the public company from getting away with such sleight of hand, Dartmouth College professor Kent Womack told the E-Commerce Times.

“If a company consistently beats expectations, it should raise some eyebrows,” Womack said. “Most analysts are close enough to a company, up-to-date enough on what they’re doing day to day, that they can get within a few pennies at the end of a quarter in one direction or the other.”

But Womack said the value of lowered expectations is visible even in the current market. After all, companies that meet or beat largely dismal earnings from a year ago, when the U.S. economy was staggering to stay on its feet after September 11th, are being rewarded with big pops on the stock exchanges.

“It’s all relative,” he noted.