Streetwise

Lauren Rudd

Sunday, April 20, 2014

Earnings Season Once Again

“The disciplined rational investor follows neither popular choice nor plays market swings. Rather he or she searches for stocks selling at a price below their intrinsic value and waits for the market to recognize and correct its errors.”   Benjamin Graham

It is earnings season once again and with it the inevitable surprises and disappointments. The question is whether you should take those surprises and disappointments seriously; or does Wall Street simply raise or lower the bar on a regular basis so that at the end of the day both the analyst and the company look good?

Companies, as a rule, do not try to mislead or lowball with their guidance. Of course a company would certainly rather error on the low side. Nonetheless, it is also to a company’s advantage to get any bad news out early.

As a rule, earnings surprises are not viewed favorably. In Street lingo, they are often referred to as cockroaches. The reason of course is that like a cockroach, you seldom see only one.

While an earnings surprise that comes as an embarrassment to the Street’s analysts might conjure up visions of cockroaches with an uncanny likeness to a company’s management, there is a bit of underlying truth to the analogy. One often quoted rule of thumb is that an earnings surprise in one quarter begets a 35 to 40 percent probability of the trend continuing into the next quarter. The theory applies to both negative and positive trends.

Needless to say cockroach theorists recommend buying on a positive surprise and selling on a negative one. The assumption being of course that those investors who were cognizant enough to recognize the trend early on will be the winners.

However, do not be too quick to enter or exit a position. After an earnings announcement, you need to analyze both the pre- and post-announcement numbers along with your own estimate, as minimal or unsophisticated as it might be. Even if your performance forecast is purely subjective, if it is significantly different from what a company announced be sure you understand why. There is nothing wrong having a different or minority opinion. After all, you might be correct.

Unfortunately, a series of events have complicated this quarter’s earnings picture. Factors such as the Ukraine and an unusually harsh winter when combined with a still fragile economy, has resulted in an investment environment that could be compared to spring ice-skating.

While everyone is wary of the possibility that the partially melted spring ice could give way; it’s just that nobody knows if or when. The trick, therefore, is to stay disciplined and not be mesmerized by Wall Street’s shifting opinions.

Despite an environment characterized by slow but steadily increasing economic growth that has come packaged with little or no inflation, inflation is still well below the Fed’s target despite the recent 2 percent reading for March, many of Wall Street’s most distinguished prognosticators are not convinced the landscape is free of bear prints. Again, much of the worry centers on earnings and the possibility that corporations simply will not make their numbers.

So it should come as no surprise that fear rather than greed rules the lives of most investors. And when it comes to investing, fear is far worse than greed. It causes you to sell too soon, buy too late, or even worse, to never buy at all. And all the while your attention is centered on the question, “But, won't stocks turn down soon?”

No one can forecast market direction in the short term. Save the precious time and effort it takes to guess and use it for more productive activities. The seers who say the market is overvalued could very well be right. However, it is an old and monotonously repetitive tune.