Watching Your Risk
Two Stocks to Consider
Earnings season is here again, that time of the quarter when thousands of companies tell investors how they performed during the prior three months and, more importantly, how they believe they’ll fare in the three-to-nine months to come. These four periods each year—generally the latter half of January, April, July and October—have become vital for investors, as stocks can make big moves in the blink of an eye.
In the old days (by old, I’m talking about 10 years ago), earnings reports were noteworthy, but not all-important. Back then, analysts would often get the “wink, wink, nudge, nudge” from a firm’s management on how the quarter was going. That would be reflected in their earnings estimates, which usually were fairly close to the actual result. (More precisely, the estimates were usually a bit low, allowing the company to beat expectations by a small amount.)
That all changed, however, when Regulation FD (Fair Disclosure) was implemented in August 2000. The regulation disallowed any of those water cooler earnings whispers with management, and it made earnings season a big ol’ crapshoot. Of course, many blue-chip stocks won’t react much one way or the other to earnings, but if you deal in strong leading growth stocks like us (especially if you have relatively large positions), the volatility around earnings time can be mind-boggling!
Because of that, more and more attention has been paid to earnings season. After all, a bad season for your portfolio—if most of your stocks gap down following their reports—can really put a damper on your entire year. But, conversely, a few gaps up can bring your results to another level!
So, obviously, the trick is to buy or own those stocks that are going to gap up, while avoiding those stocks that are set to gap down. Easy! Well, not exactly. We’ve looked at it from every point of view—charts, fundamentals, etc.—and we haven’t found a way to predict what a stock will do following a firm’s report. Again, it’s all about Regulation FD; the news can’t be leaked, and so the results aren’t really reflected in the action of the stock until after they’re reported.
That said, having lived through many earnings seasons, I do have a few pointers that can help you survive and prosper during these tough periods. Here are my top five guidelines for helping you deal with this volatile period.
1. First and foremost, avoid taking any big-sized positions immediately before a growth stock’s earnings release. You can find earnings release dates in a variety of places online (including Yahoo! Finance under Company Events). Taking a big position right before the report is more like gambling than investing, and eventually, you’ll get burned.
2. Always calculate your potential risk and reward when holding a stock into earnings. This doesn’t have to be a complicated math equation, but just ask yourself, “If this stock gaps down 10% or more on its report, how bad will my portfolio get hit? And if the stock gaps up 10%, how much will that help my portfolio?” Picturing the potential joy and pain will usually let you know whether you’re truly comfortable with the size of your position.
3. Here’s a trick that can help you avoid some losers—go back and look at the stock’s reaction to its last three or four earnings reports. If it’s gapped up the past two or (especially) three times, you might be on thin ice. In fact, I don’t think I’ve ever seen a stock gap up four times in a row; by that point, the story is usually too obvious and expectations are too elevated. So consider selling a portion if you’re in an extended leader that’s already gapped up a few times in a row.
4. Use earnings season to your advantage by constantly scanning for names that gap up sharply following their report. By sharply, I’m talking about 10%, 15% or more, and on huge volume to boot; such gaps may seem like good times to sell, but our studies show that such gaps lead to higher prices seven or eight times out of 10. That’s especially true when you’re talking about a relatively liquid leading stock; the success rate isn’t as good if you’re dealing with low-priced, thinly traded issues.
5. Last but possibly most important, formulate a game plan. I realize this advice is very vague, but my experience is that there is no single way to handle earnings season … but if you make emotional moves, you’ll likely get twisted in knots. I know some investors that hold full-sized positions heading into earnings (as we generally do in Cabot Market Letter) and others that never hold anything through a report—and both do OK.
But the key is that these investors have a consistent game plan and stick to it. The investors who suffer during earnings season are those who act based on how they feel—they’ll hold on to a couple of stocks because they’re bullish, but if those gap down, then they’ll prune back on other stocks ahead of earnings … and those are the ones that gap up!
In total, earnings season is a tricky and often dangerous time, but it can also be a time that pushes some of your stocks to dizzying heights and reveals new leadership (in the form of huge earnings gaps higher) that is just taking off. Incorporating the simple guidelines above should help you make the most of this volatile time!
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As for the market itself, the rally that began on September 1 continues to look good, though there’s clearly some rotation going on underneath the surface. Last week, most stocks related to the cloud computing movement topped out, at least in the intermediate-term. That’s not to say all those names are going to zero, but at the very least, cloud stocks are going to have to take a few weeks, if not months, to rebuild some bases.
My point here is that, even though we’re in a general bull trend, you don’t just buy stocks and sit on them for six months. You must monitor your holdings, especially as earnings reports start coming out. And the plan is relatively simple—get rid of any stocks that break down, take a few profits (or partial profits) on the way up, and always be on the lookout for new leadership stocks at logical buy points.
One way to find new buy candidates is to identify already-strong stocks that don’t report earnings for a few weeks that have tightened up ... a sign that big investors aren’t unloading shares despite the recent run-up. One idea on that front is Silver Wheaton (SLW), part of the super-strong precious metals group. The stock recent marched higher an impressive 11 weeks in a row on big volume. Sales and earnings growth are huge, and the stock has been chopping around the 26-to-28 area for three weeks. A shakeout down to 25, or another week or two in this range, could present a new buy point.
Another option when building your Watch List is to look for a big, liquid leader that has the potential to gap up on earnings. One near the top of my own list: Amazon.com (AMZN). While the Kindle e-book reader is still selling well (thanks to a recent price cut), I think the bigger story is simple—e-commerce is becoming a larger piece of general retail sales, and Amazon itself is becoming a bigger chunk of e-commerce sales!
I also like that, after a good run in 2009, AMZN really did nothing from January through the end of August; that’s enough time, with enough of a correction, to shake out all the weak hands. However, after finding massive-volume support along its lows in July, Amazon tightened up in August and then moved straight up in September, from 131 to 162.
Now shares have chopped around for three weeks as investors wait on earnings, which are due out next Thursday. Any substantial gap up would be a green light to dive in.
All the best,
For Cabot Wealth Advisory
Editor’s Note: Cabot Market Letter, our flagship newsletter (which is celebrating its 40th birthday this week), has more of Mike’s expert advice on other leading stocks and the market timing indicators you need to profit from them. And Mike’s newest report, The November Surprise, has the 10 top stocks to profit from this fall! Learn more here.