The months following the end of every quarter (January, April, July and October) are when the majority of corporate earnings are released, a time commonly called earnings season.
This is typically a volatile period in the markets because earnings announcements are the scorecard by which investors know how their investments are doing, and provide information about how they may do in the future. The media is full of reports of companies that beat or missed estimated earnings, and stocks get jumpy.
This can be a time when average investors are tempted to buy into the fever and jump in or out of positions based on earnings announcements. However, before doing so, investors should consider that all may not be exactly as it appears at first glance. Companies, analysts and pundits may have incentive to guide earnings to their benefit. So when investing during earnings season, consider the following:
- Companies often spin their earnings to their advantage. Companies often try to highlight positive information and ignore or play down bad news. For example, a firm that usually announces their headline number as bottom line growth, could change the announcement to read the same except using top line growth. There's a big difference between top line income and bottom line profits.
Also, they could announce an unexpected development such as a new customer, product or market that has big potential but hasn't actually happened yet to deflect attention away from a bad quarter. Even an announcement of a stock buyback, often a good thing for shareholders, may be a diversionary tactic.
- They add to a bad quarter to get all the bad news out quickly. If things are bad and the company can use an external excuse, such as the credit crunch or recession, then they have an opportunity to package other bad news with it that they have been saving for just such an occasion. For example, they can write down inventory that should have been written off quarters ago, and blame it on economic conditions, not lackluster sales performance.
- Hidden items in the footnotes. Both the amount and importance of the footnotes of an earnings report has increased. Some are used to explain accounting rules that are meaningless and others are unbelievably significant. A historic example of this is the now infamous footnote 16 from Enron that described some off balance sheet transactions that appeared meaningless. (Enron is a classic example of greed gone wrong - and how investors were led astray. To learn more, read Enron's Collapse: The Fall Of A Wall Street Darling.)
- Strong results don't mean the stock is going up. Novice investors will see a great past quarter and think that the company is doing well. What it really means is that it did well in the past. The question now is will it continue? Future guidance is the key. If the management hedges on the pace going forward, the market may even sell off on a great earnings announcement. Similarly, even when missing earnings estimates, stocks can rise if the company forecasts a rosy future outlook. But before you accept that, see number 1 above.
- Great companies often downplay expectations. The guidance going forward is important and the companies know that everyone is watching. So instead of talking up the firm, if they downplay expectations, then they can have an easier time of meeting consensus estimates. Companies like Microsoft beat earnings estimates so regularly, and by very similar amounts, that beating the estimate isn't a surprise anymore.
In fact, if they came at consensus that would probably be viewed as a miss by the market. So just because a company doesn't rave about future growth doesn't mean it won't be there.
When investing during earnings season, remember the news may not be as it appears at first glance and that typically this is a very short-term active trader's market. If you are a buy and hold investor, probably best to leave earnings season trading to others and concentrate on long-term holdings in solid firms. (To learn more about estimates and trading in earnings season, check out Strategies For Quarterly Earnings Season.)
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