7 Rules for Earnings Season

 

It All Started with Regulation FD

7 Rules for Earnings Season

A New Earnings Winner

When I first started to get interested in stocks, earnings reports would only impact stocks in a relatively minor way-maybe by 3% or 4% one way or the other-if the company beat or missed analysts' expectations.

But then Uncle Sam implemented Regulation FD to level the playing field between the average Joe and the Wall Street titans, and that changed everything. For better or worse, most big, institutional investors don't really know exactly how a company is doing, and even if they do, they have no idea what management is thinking in terms of the coming quarters, spending plans and the like.

And that uncertainty has resulted in earnings season being one big festival of gaps up and down, especially among the high relative strength growth stocks I focus on.

However, with uncertainty comes opportunity, and so I want to lay out my top seven rules for handling earnings season. These rules stem from some of my off-the-cuff observations as well as real, hard-and-fast studies back in the 2002-2003 timeframe. I've been using these guidelines ever since to not only survive earnings season, but to find new leadership and ultimately, make money.

Seven Rules for Earnings Season

1. The most important thing at earnings season (and really, at any time in the stock market) is to have a plan and be consistent. In my case, I generally hold every stock through earnings. If you instead want to take less risk-say, by selling one-third of your shares ahead of earnings-that's fine, but do it for all your stocks.

Another option is a plan that lets you hold through earnings if you have a profit, but sell some shares ahead of earnings if you don't.

There is really no right or wrong approach, but you should have a plan AHEAD OF TIME and stick to it.

2. Stocks with large earnings gaps (10% or more for most stocks; 7% or more for mega-cap names) tend to continue in that direction in the intermediate-term (next four to 12 weeks). Such large earnings gaps represent sudden changes in perception (good or bad), which tends to persist.

Obviously, the conditions of the overall market will have a lot to do with that, but even in a terrible market, you'll usually see earnings winners hold much more firmly than average stocks.

Volume is also important-quadruple average volume (or more) usually represents intense buying. I also like to see that it's the largest volume in nine to 12 months as a sign that the buying/selling pressure was extreme.

You also want to make sure the stock in question has good fundamentals-but use the chart to find a good time to buy a stock you're interested in.

3. The very best earnings gaps happen just as the market is turning up after a multi-week correction and after the stock has been basing (building a launching pad) for many weeks. The classic example was Facebook (FB), which went through the wringer for months after its IPO, but then gapped up in July 2013, just a couple of weeks after the market came out of its own correction.

Notice how, even though FB rose 30% (!) that day, with volume eight times average, it was a great buy. It never really came back down, which leads me to another point ...

4. A characteristic of the most powerful earnings winners is that the stock will never trade below the low of the earnings day. (For example, in the FB chart above, the stock never traded below 32.75, which was the low of the day it gapped up on earnings.) I don't necessarily advise putting a stop order just below that day's low, but that is an option if you're a bit nervous about buying a highflying name.

5. Another thing to watch for is the "double-barrel" earnings buy signal. Big earnings-induced moves aren't overly rare these days, but if you get a big, 10%-plus earnings rally one day ... and then you get another huge-volume (more than double average volume) rally of a few percent the next day, that is a sign that institutions are piling in. Interestingly, I'm seeing a few of these sorts of moves in the current market (more on that below).

6. While I'm always looking for young, "emerging blue chips," you should definitely NOT ignore mega-cap stocks that stage big earnings moves (maybe 7% or more on at least triple volume-the bigger the better). While they're unlikely to double or triple, these stocks can often rally 20% to 40% in a straight line over a few months, rarely testing you in any meaningful way.

7. On the downside, the most bearish earnings gaps occur in stocks that have had major moves during the past many months and are thought of highly. When a popular stock that's run for a year or more gets crushed on earnings, look out below. Crocs (CROX) was an example of this, and again, the bigger the move the more meaningful-CROX fell 36% the day after its earnings in the fall of 2007, and never bounced back.

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The current market environment remains range-bound, and I'm keeping a decent amount of cash on the sideline. That said, I'm starting to see more and more things I like-the major indexes, for instance, seem to be shrugging off the various worries of the day (junk bond issues, Greece, China slowdown, future Fed rate hikes, etc.), which is a good sign.

But the most encouraging thing I see is a bunch of earnings gaps, and the stocks that surged on earnings have both held their gains and, in most cases, built on the gains in the days that followed.

In other words, these earnings winners are acting like they're "supposed to," which isn't something we've seen much of during the past few months in the market.

One enticing candidate is Harman International (HAR), which soared 24% on seven times average volume in reaction to earnings on January 29 ... and then surged another 4% on quadruple average volume the day after. It's traded tightly since, holding all of its gains. Here's what I wrote about the company in Cabot Top Ten Trader two weeks ago:

"It might be a little fanciful to ascribe Harman International's recent surge to low gas prices, but there's some truth there. Harman makes top-of-the-line audio gear like speakers, CD players, amps and the like for all kinds of installations. But the auto segment has been the biggest driver of growth, as the company's relationships with BMW, Audi and other high-end marques give it great exposure in the auto biz, and low gas prices are certainly encouraging consumers to shop higher on the food chain than they ordinarily would. Whatever the reason, Harman's fiscal Q2 report last Thursday was across-the-board strong, with revenue up 19% and EPS up 64%, both well above analysts' estimates, and the company's 8% after-tax profit margin was also the highest in years. The company also got support from its home and professional products and services lines, but cars were the big story. Consumers are looking for Internet-connected audio and entertainment options, and Harman does those very well. To complete the picture, Harman also raised its estimates for the remainder of its fiscal year through June-and there's a dividend with a 1.0% annual yield."

With HAR beginning to calm down, I wouldn't be surprised to see a minor shakeout or two going forward, especially if the market has another dip toward the lower end of its trading range. But I think the stock is buyable around here or on dips of a few points, with a 10% loss limit.

Receive more updates on HAR as well as additional momentum stocks featured in this week's issue by taking a risk-free subscription to Cabot Top Ten Trader. Last year, we grabbed many double and triple-digit winners in a short period of time, including 89% gains in VipShop Holdings and 55% gains in YY Inc. in just two months, 120% gains in Bitauto Holdings and 57% gains in Spansion Inc. in just 3 months and we see many more strong stocks that have the possibility to be this year's winners.

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Sincerely,

Michael Cintolo
Chief Analyst of Cabot Market Letter
And Cabot Top Ten Trader


Michael Cintolo can be found on Google Plus.

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