Why Earning Seasons?
Earnings Hits and Misses
How to Play Earnings Season
On Monday, Alcoa (AA) served up its Q2 results for the investing world to see. If the stock-investing world has an equivalent of the swallows coming back to Capistrano (which signals the arrival of Spring) or Mardi Gras (which marks the beginning of Lent), it's Alcoa's earnings release, which means we're in for another round of Earnings Madness.
For some reason, maybe lost in the mists of time, Alcoa is traditionally the first big company to drop its numbers every quarter. This time (Q2, 2013), the news came out after the market closed on Monday, which was July 8. That's pretty quick work. And the news from Alcoa was modestly positive, with the company posting a net loss due to some exceptional items, but generally in line with analysts' expectations. The reaction from the stock was predictably subdued, with no big moves in either direction. (The people who hold AA probably do so more for the 1.5% annual dividend yield than for its price appreciation.)
But earnings season can also have a huge impact on a stock's price, so I'm going to give you a quick walk through the world of quarterly reports (a “backgrounder” as they say in the news biz) and list a few rules that will let you get through a year's worth of earnings without blowing a gasket or reducing your portfolio's value too much.
WHY EARNINGS SEASONS?
Why are there earnings seasons? It's because the Securities and Exchange Commission (SEC), which writes the rules for equities listed on U.S. stock exchanges, says so.
According to the SEC, every publicly traded company has to file a Form 10-Q (for quarterly) unaudited financial statement for each of the first three quarters of the company's fiscal year. And at the end of the fiscal year, there must be a 10-K report, an official, audited disclosure of all significant financial information.
Just as a side note, there's really no reason for a company to have its fiscal year conform to the calendar year. Many retailers have fiscal years that end in January, which gives them until February to start thinking about reporting. Who wants to run the gauntlet of the Holiday Shopping Season and then dig into putting together an annual report? In fact, companies' fiscal years end in virtually every month. Maybe they get a discount on their auditing for avoiding the peak season?
Big and medium-sized companies get 40 days from the end of the quarter to file. Small companies (market cap of $75 million or less) get 45 days. Annual reports are due within 60 days of year's end from companies with a market cap of $700 million or more, 75 days for companies whose market caps are $75 million or more, but less than $700 million, and 90 days for small caps (less than $75 million).
EARNINGS HITS AND MISSES: SO WHAT?
Most of the evidence that equity investors use to decide on which stocks to buy is probabilistic. There are no guarantees. A company that has been growing revenues and earnings quarter after quarter may keep the string going … or may not. And a stock with a low P/E ratio and good growth prospects may be ready to start climbing … but not yet.
But earnings season, when investors compare companies' results with the “consensus numbers” (an average of the estimates of all the analysts who are following that company) is generally pretty clear in its verdict. If a company is supposed to make a nickel per share but makes six cents, that's a beat. Everyone's happy. If revenue was supposed to top $200 million but the report says $199 million, that's a miss. Nobody's happy.
Hitting the consensus numbers generally supports a stock's price. Exceeding the number often leads to a jump in price, including the “gap up” that investors love to see. A stock that pops higher on the day after earnings (especially if volume has also spiked higher) often gets a dose of momentum that will power it to further gains.
Here, for example, is a chart of Cree, Inc. (CREE) showing what happened on January 23 when the company hit the trifecta of beating expectations on revenue, earnings and guidance for future results. (The second gap up on March 6 resulted from raised guidance and the debut of a line of low-priced, energy saving LED light bulbs.) An 18% gain in one day is an attractive possibility.
There are exceptions to all of these rules, of course. If management gives a convincing reason for the miss, or issues positive guidance to future performance, the damage can be contained, or even reversed.
SO HOW DO I PLAY EARNINGS SEASON?
The way to play earnings season depends on whether or not you own the stock whose report is coming up.
If you own the stock, you have four choices:
If you own the stock, you have four choices:
1. You can just sit there and trust to luck. If the stock goes up, you’re a genius. But the converse is also true.
2. You can sell part of your position ahead of the report. If you have a profit, this will lock part of it in, while still giving you exposure to a possible advance.
3. You can set a loss limit on the stock, which may get you out of the position with less damage. The problem here is that a disappointing report, especially one that comes out after the market closes, can produce an opening price the next day that’s way below your stop.
4. You can buy an option that will allow you to make money even if the stock tanks.
If you don’t own the stock, you also have three choices:
1.You can buy the stock (or short it) ahead of the report. This is the least attractive option, as you have no real idea of how likely the report is to beat expectations. It’s a little like playing Red on a roulette table.
2. You can wait for the report and then jump in quickly if the stock gaps up on good volume. Our research shows that a stock that gaps up on volume usually gets a longer-lasting boost that will keep pushing it higher.
3. You can buy an option that will give you a profit if the stock reacts big either way.
My own preferred way to play earnings season is not to play it at all. I keep track of when reports are due from the companies whose stock I own and then pay close attention to the reaction to the news. By using my usual loss limits, I can limit my downside, although a big miss can still hit hard enough to leave a mark. But if you’re picking good stocks, your gains will outweigh your losses.
If you want to know when your companies are reporting, the most reliable guide is the Investor Relations area on the company’s website. You can also try websites like Yahoo Finance. Go to the specific page for your stock and look in the left-hand column for “Company Events.” Just remember that any date for an earnings release that isn’t accompanied by an official message from the company itself is likely just an estimate of the predicted week for the report.
Good luck with your holdings this earnings season.
My stock pick this week is really intriguing. Back in 2004, China Automotive Systems (CAAS) was a pick in the Cabot China Investor (the predecessor to Cabot China & Emerging Markets Report, which I write) in the October 21 issue. Then, as now, the company’s biggest product line was components for automotive steering systems, which it sold to makers of both autos and commercial vehicles.
It was a heady time for an auto parts maker, with only 1% of Chinese owning a car and auto sales soaring by 62% in 2002 and 75% in 2003.
The young stock was just starting a long period of roller coaster action that made it hard to buy and even harder to make money on. In 2009, China Automotive began the year trading at 3 and shot to as high as 26 in January 2010. But after that, it was all downhill for the stock until it skidded back to 3 in early 2012.
I’m spending a lot more time on the chart for CAAS than on the company’s great story for one big reason: the chart for CAAS has gone totally ballistic since the beginning of July, ripping from 5.25 to as high as 8 in just seven trading sessions. And that price blastoff is supported by a huge ramp up in trading volume. Clearly, someone has decided that it’s a good idea to own a lot of CAAS.
Ordinarily, I would be talking about the company’s redemption of its convertible notes and the $5 million stock buyback instituted in August. I’d point to its joint ventures with General Motors, VW and Peugeot Citron and its position as a parts supplier for Jeep Wranglers and Dodge RAM pickups. And I’d note its new joint venture in Brazil.
But for now, the chart is the big story. As often happens, a big move in a stock doesn’t always have an easy explanation. We may not know who’s doing the buying, or why, for some time. But for a growth investor, a breakout move like the one CAAS has just put on is always eye-catching. Here at Cabot, we believe in the old adage that “The most bullish thing a stock can do is go up.” So we’ll have our eye on China Automotive Systems. You should too.
Editor of Cabot Wealth Advisory
and Cabot China & Emerging Markets Report