With earnings season in full swing and beautiful bike riding weather tempting me, I haven't been writing too much lately. Furthermore, my wife and I are expecting our first baby (a daughter) in about 7 weeks, so I've been hunkered down conducting intensive research on girls-only day care, nunnery applications, and state gun permitting laws.
But earnings season is finally winding down, and I'm sufficiently recharged to once again form complete sentences. With earnings still fresh on the mind, I thought I'd share a few thoughts about earnings season. First of all, I think the idea of quarterly earnings reports is ridiculous. Company management is supposed to be focused on building long-term value, and quarterly reporting only encourages an emphasis on short-term results. It's a tremendous distraction. Twice-a-year reporting would make much more sense -- and not just because it would interfere only half as much with my bike riding.
I've been asked a number of times about my opinion on trading in anticipation of an earnings miss or beat. This isn't surprising since there are plenty of bloggers/gurus/charlatans/hucksters/frauds/Street.com personalities and Wall Street analysts offering their opinions about which stocks you should trade heading into earnings season. I'm not a big fan of placing these trades. The difficulty lies in the fact that the stock may not rise or fall just because it met or missed earnings expectations. Here are a few of the possibilities:
- The company could report a great quarter, and the stock goes up.
- The company could report a great quarter, but it might not be as strong as the market was expecting so the stock gets hit.
- The company could report a great quarter but guide the next quarter down, so the stock gets hit.
- The company could report a great quarter and an SEC investigation, so the stock gets hit.
- The company could report a great number, but the quality of those earnings could be poor, and the stock gets hit.
- The company could report a great number and a stock offering, so the stock gets hit.
- The company could report a great number, but the stock had run up in anticipation of the great number, so investors take profits on the news (buy on the rumor and sell on the news).
- The company could report a bad quarter, and the stock gets hammered.
- The company could report a bad quarter, but it might not be as bad as feared, so the stock goes up.
- The company could report a bad quarter but announce that it's pursuing "strategic alternatives" so the stock goes up.
- The company could report a bad quarter but offer strong guidance, and the stock goes up.
- The company could report a bad quarter and a stock buyback, and the stock goes up.
- The company could report a bad quarter, but the Street might believe that the worst is over, and the stock goes up.
First of all, if I'm buying, then I must feel very confident that the company will beat expectations AND/OR raise its guidance. If I'm shorting, then I must believe that the company will miss expectations AND/OR guide lower. The trade also has to be consistent with my view of the company's valuation and fundamentals. I'm not likely to short the stock of an inexpensive company with great fundamentals, and I'm not likely to buy the stock of an expensive company with poor fundamentals, regardless of the time frame.
Rather than take a new position just before an earnings announcement, I usually prefer to see the market reaction following the earnings release and possibly the conference call. Especially in volatile times like these, investors tend (in my opinion) to be prone to overreacting to news. Of course, the stock reaction has to be out of proportion to the news. These overreactions are more likely to occur during after hours trading when liquidity is relatively thin. I only placed one of these trades this earnings season, and it was a purchase of MEMC Electronic Materials (WFR) after hours on July 23rd following a poor earnings release. The stock was purchased at the mid-$38 level when it was briefly down about 30%. The position was sold the following morning just shy of $45.
So what should you do? Place a trade in anticipation of some earnings outcome, or look for over-reactions following earnings releases? You probably shouldn't be doing either. It's very difficult to make money consistently with any short-term trading strategy, and you're up against pros with far more experience and far better contacts. Stick with the long-term, focus on valuation and the fundamentals, and go for a bike ride.
Disclosure: The Rubbernecker is long post-earnings season lobotomies but short earnings season.
