Every three months a fresh earnings season comes around to challenge investors. They worry what will happen to their stocks when earnings are announced. While some investors wait by their computers and televisions to buy and sell on the reports, others choose to ignore the earnings news completely.
Neither strategy is a good one. We've come up with four solid strategies that will give any investor a leg up on the surrounding chaos.
Expectations rule. A combination of analysts and management guidance establish the earnings expectations that everyone references. Sometimes it makes sense, but other times earnings expectations have no solid basis. But that doesn't stop the majority of investors from acting on the news.
Investors and analysts set the bar outrageously high. Share prices can (and usually do) fall if a company misses expectations by a penny, as traders sell on the news. Even if a company's earnings exceed expectations, if it doesn't beat it by a wide enough margin, investors may still decide to sell.
But consider what these announcements really mean: If the earnings are off by a penny or two, it is not a catastrophe -- as long as the underlying fundamentals remain solid. These momentary bucks in the share price provide a great buying opportunity for interested investors.
Real World Example -- On October 18, 2010, IBM (NYSE: IBM) delivered third-quarter earnings of $2.82 a share -- six cents higher than the $2.76 a share that analysts expected. Yet IBM's share price fell $4.80 (-3.36%) on the day following their announcement. Management even raised their profit expectation for the full year. Since the fundamentals on IBM remain solid, any pull back in IBM is creating a buying opportunity, especially if it falls to a good support level.
It takes more than one point to make a trend. A company's earnings release only reflects its financial results for the last three months. If one of your investments misses the earnings boat, don't panic -- you may be turning a mole hill into a mountain.
Look at the trend in earnings over several quarters to assess whether there is a reason to be concerned. (You can usually find old earnings reports in the "Investor Relations" section of the company's website.) Assuming no major change in the company's fundamentals, if the trend in revenues, earnings and cash flows remains positive, you can rest assured that the company will continue to do well.
If there is a break in the fundamental trends, dig deep to uncover what's causing it. If it is a one-time aberration, you might have a good buying opportunity on the dip in the price. On the other hand, if the fundamentals are deteriorating, it's probably time to get out.
Real World Example -- On October 20, 2010, Morgan Stanley (NYSE: MS) reported earnings of $0.05 per share, well below expectations of $0.15, and no where near last year's third quarter earnings of $0.50. The fall in earnings was due to lower trading profits in the quarter. While trading profits are highly volatile, and therefore difficult to predict, MS's low earnings weren't just a fluke -- the company continues to face the challenges from the mortgage securitization business as well as its institution securities operation.
If a company's earnings trends continue to flatten (like Morgan Stanley's), use the opportunity to get out and find another company that's on a nice up-trend.
Listen to the conference call. The quarterly conference call is available to anyone, though it is primarily for the analysts that follow the company. Most of the time, management is candid in their comments and in their response to questions. The calls are recorded and available for at least 30 days (usually in the "Investor Relations" section).
Listen for any cautious statements from management that may seem out of the ordinary. If you hear hints that revenues might be lower, the company faces a challenging sales environment, margins are narrowing, or other new threats to the business, raise a red flag. This could be a hint that more problems are on the horizon.
Real World Example -- During Boeing's (NYSE: BA) conference call, management indicated the growth in the defense business would be challenging, but still believes it is stable. They also suggested that there would be additional job cuts as defense spending, Boeing's primary growth driver, slows. However, Boeing also said the growth in the airliner business is picking up and that the future looks bright -- especially as interest in the 787 Dreamliner remains strong.
In a candid comment, management indicated that the fixes on the wheel well problem of the 787 are "in place," meaning they do not anticipate any further delay in the flight-testing of the 787. The first delivery to a commercial customer remains mid-first quarter 2011.
The airliner business appears to be replacing defense as the growth driver. As long as defense remains stable, the future looks good for Boeing.
All this additional insight about the company can give you a better insight into the future. But if you don't listen to the conference call, you might miss it!
Peruse the 10-Q and 10-K. The Securities and Exchange (SEC) requires companies to report their quarterly and annual results in a structured format. These reports contain a lot of in-depth information that can further explain the company's earnings results.
The first thing to check out is the cash flow statement; this will help to assess how well the company is generating cash. This is normally the first place problems show up. In particular, look at the free cash flow yield and its trend over time. If you note a downward trend, try to find what's driving the change.
Real World Example -- On October 19, 2010 Cree (Nasdaq: CREE), the LED lighting company, reported that its revenues grew by +59% and earnings leapt up +175% over the prior year quarter. Cash flow from operations for the three-month period was up +45%, while free cash flow fell -34%.
Is that a reason to worry? It could be. Cree's free cash flow fell because it upped its capital spending, by +202%, which is common for fast growing company. However, cash flow for the latest quarter fell from $94.9 million to $88.5 million. Once we get the 10-Q, we can dig deeper to see if this is a sign of a larger problem.
Each earnings season brings new challenges and volatility to the market. As this volatility pushes down the share prices of quality companies who missed the earnings boat, it creates boundless opportunities for bargain hunters. Successful investors take advantage of these dips in the price to pick up stocks of companies that have great fundamentals. All it takes is some homework before and right after the company's earnings announcement.
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