Welcome to the second earnings season of 2012. Alcoa kicked off the season with a big surprise that has stirred a mini rally in the commodity world.
There are a lot of companies that will be announcing their earnings in next few weeks. The bigger and more established stocks tend to be first to announce earnings. The smaller stocks announce earnings later in the season.
Why do we really bother about earnings –
Back in 1968, accounting professors Ray Ball and Philip Brown famously showed that shares of companies that surpass consensus forecasts tend to perform better than the broad stock market; the phenomenon, which has been backed up by more recent studies, is known as post-earnings-announcement drift, or PEAD. FYI – The same Wall Street analysts who give buy, hold and sell advice on stocks make estimates of quarterly earnings, and pollsters gather those estimates to form a single consensus for each stock that analysts follow.
If the earnings is a major surprise compared to the expectation then the stocks react immediately to the news. Most of the time the stock will make 8 to 25% move on earnings day itself. The investors, in a perfectly efficient stock market, would think that the good news is priced in now and shares of forecast beaters would tend to perform in line with the market afterward. But hold on folks – the most interesting part of PEAD is the D. Shares indeed often leap on good earnings news, but afterward, they tend to gradually drift higher for months.
But not all the earnings surprise are dealt with equally – some companies are just market’s favorites – just kidding!. Nowadays, so many companies regularly beat their earnings forecasts that surprises aren’t always, well, surprising. Some of these companies set the bar low; others perform the accounting equivalent of searching the couch cushions for loose change just before the end of the quarter. Companies long ago got wise to the game, however.
Let’s leave that aside and figure out how to profit from the rigged system and make the best of the D. The gradual nature of PEAD suggests that even slow-poke traders can take advantage.
Ways to profit from profit –
1. Look for firms that beat forecasts by a lot rather than a little. Their results are likely driven by strong operations rather than accounting tweaks.
- CSTR reported 4th quarter 2011 earnings of $1.00 per share on February 6, 2012. This beat the $0.64 consensus of the 17 analysts covering the company.
- SCSS reported 4th quarter 2011 earnings of $0.27 per share on February 8, 2012. This beat the $0.22 consensus of the 9 analysts covering the company.
- ALXN reported 4th quarter 2011 earnings of $0.41 per share on February 9, 2012. This beat the $0.34 consensus of the 19 analysts covering the company.
- ASGN reported 4th quarter 2011 earnings of $0.20 per share on February 14, 2012. This beat the $0.16 consensus of the 4 analysts covering the company.
- AAPL reported 1st quarter 2012 earnings of $13.87 per share on January 24, 2012. This beat the $10.16 consensus of the 48 analysts covering the company.
2. Look for companies that beat revenue forecasts at the same time they beat earnings forecasts. e.g. is RHT. Companies that top earnings estimates alone might have done so through cost-cutting, which is fine, but opportunities for cost-cutting can run out quickly. Companies that outperform on revenue, too, are likely benefiting from growth.
A 2006 study published in Financial Analysts Journal found that at any given point, the top 20 percent of companies ranked by recent upside earnings surprises alone went on to beat the market by three percentage points, on average, over the subsequent six months. The top 20 percent by upside revenue surprises beat the market by 2.6 percentage points. However, the top 20 percent ranked by a combination of earnings and revenue surprises beat the market by 5.3 percentage points over the following six months.
In fact a study slated for publication this year in the same academic journal: Watch investor reaction to the earnings reports. “If investors are truly surprised by an upside earnings announcement, the stock price should jump in the short-term,” explains author Haigang Zhou, a professor at Cleveland State University. Zhou and a colleague looked at returns from 1971 to 2009 and found that firms with upside earnings surprises followed by unusually high price gains over the next three days went on to beat the market by 5.7 percentage points over the subsequent 60 trading days.
When to buy them?
Let’s look at the charts of companies that deliver consistent earning’s surprises –
CSTR reported 4th quarter 2011 earnings of $1.00 per share on February 6, 2012. This beat the $0.64 consensus of the 17 analysts covering the company.
SCSS reported 4th quarter 2011 earnings of $0.27 per share on February 8, 2012. This beat the $0.22 consensus of the 9 analysts covering the company.
ALXN reported 4th quarter 2011 earnings of $0.41 per share on February 9, 2012. This beat the $0.34 consensus of the 19 analysts covering the company.
ASGN reported 4th quarter 2011 earnings of $0.20 per share on February 14, 2012. This beat the $0.16 consensus of the 4 analysts covering the company.
AAPL reported 1st quarter 2012 earnings of $13.87 per share on January 24, 2012. This beat the $10.16 consensus of the 48 analysts covering the company.
Earnings offer a lot of opportunities for profitable trading.Most big stock moves start with an earnings surprise. Behind every major multi month or multi month move there is an earnings story. PCLN, AAPL, LULU, SCSS, ULTA, ALXN,BWLD, and many other long-term movers have been primarily driven by their earnings trend. The earning season provides you with the ability to identify such stocks right at the start of their possible multi month move.
As explained above, most of the time the stock will make 8 to 25% move on earnings day itself. But this is not the end of the opportunities unlike the common perception. The stocks continue to drift higher. In these stocks even if you react to earnings and enter after the earnings announcement, you still can catch bulk of the move.
One earnings surprise is typically followed by many more earnings surprises. It is almost as if stock’s earnings have gained momentum. When you focus on first earnings acceleration there is good chance your stock will have more such earnings. So effort spent in researching stocks during earnings season can pay you off for many quarters. The structural factors which contribute to earnings acceleration do not disappear in one quarter. That is why earnings trends persist and price trends persist.
So during this earnings season pay attention to stocks that have significant earnings surprise or miss.
When you need to be careful about buying surprises –
There are periods when market goes sideways or goes into correction. During such periods even the best of the best earnings get beaten up. The fundamentals haven’t changed but market is not on your side. Just be patient. Good earnings tend to go sideways during correction.i.e. a correction of 20-25% max with a channel formation or even flag formation or consolidation. This holds good only during correction and not during recession.
So you see above that though the market corrected, the leaders hung in. In fact the market seems to have corrected more than AAPL of PCLN.
In a good market don’t follow the herd mentality. Do exactly the opposite! George does it.