Time to Gear Up for Earnings Season

“Concentrate on stocks with proven records of significant earnings growth in each of the last three years plus strong recent quarterly improvements. Don’t accept anything less.” – William J. O’Neil, MarketSmith Founder

With the advent of the New Year, it is time to gear up for third quarter results from companies. If stocks report their results better than expected, their prices could roar higher from current levels. On the contrary, they could drown lower into their bases if the reported numbers miss street expectations.

Top Five Things to Look for During Earnings Season

– Watch for sales and earnings per share (EPS) growth of at least 20–25%. The company probably has a product or a service that is selling like hot cakes. You need to know what‘s happening here!

– Rather than a fluke quarter, watch for an average sales and EPS growth of 20–25% over the last three quarters. This trend confirms your theory that the company could be up to something that the others are not able to achieve.

– Watch for acceleration in earnings growth rate. Our studies on big winning stocks have shown that big price moves follow such accelerations in earnings.

– Look if the current quarter’s earnings are up in percentage terms from the same quarter a year before. Such a comparison could help remove any effect of seasonality.

– Simply avoid taking new positions in a stock if its results are due in a week or earlier. Booking your profits and staying away from the stock before its results is not a bad idea. You can always get back in the stock.

How to Play this Earnings Season?

Buying a stock during the earnings season, before results are announced, is very tricky. First, it is hard to know whether the company will beat, miss, or meet the street expectations. And second, it may be even more difficult to guess how shares will react to the report. Simply avoid taking new positions in a stock if its earnings report is due in a week or so. Your strategy to invest in shares should not involve any guesswork. You need to be ready to hold your card if you think probability could work against you. In that case, you are giving volatility an upper hand. You should simply avoid it if you have even the slightest whiff of risk. Stocks tumble the hardest if they miss their earnings estimates. The following example shows how a leading pharma stock corrected sharply after missing market expectations:

How Much Growth is Good Enough?

Have you ever read a corporation’s quarterly earnings report that stated, “We had a poor quarter. The prospects of our company are turning down due to inefficiencies in operations. Our competition just came out with a better product, which will adversely affect our sales. Further, we are losing our shirt on the new operation, which was a real blunder on management’s part.”

No! Here’s what you could probably see:

“Our company reported record sales for the quarter. Sales were up 20% on a comparable basis.”

If you own their stock, this is wonderful news! You certainly are not going to be disappointed. You will think this is a fine company (otherwise you wouldn’t own its stock!), and the report confirms your assumption. This is known as the confirmation bias. Information is viewed as confirming evidence for your existing beliefs without any second thoughts!

Does this record-breaking sales announcement make for a good report? You might need to look at a few other things.

What if its EPS was up only 5%? Its sales jumped 20%, surely, but why did the profits remain so low? Something might be wrong—maybe the company’s margins are crumbling. If you own the stock, you should be concerned at any rate and evaluate the situation closely to see why earnings increased such a trickle.

Let’s say your company discloses that sales climbed 10% and net income advanced 12%. This sounds good, but you shouldn’t be concerned with the company’s total net income. You don’t own the whole organization. You only own shares of stock in it. Perhaps the company issued additional shares resulting in the dilution of the common stock. Just because sales and total net income for the company were up, the report still may not be favorable. Maybe EPS of the common stock inched up only 3–4%.

Always remember, the devil is in the details. You need to put on your detective hat and look through the company’s slanted presentations!

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