Just like nature, Wall Street has its own cycle of seasons, and with the calendar now in October, companies are gearing up to report their next round of earnings. Given that earnings can dramatically influence a stock's price (over both the short and long term), it is clearly an important part of every investor's schedule. With that in mind, here are a few points to consider as the markets gear up for the next earnings cycle. (For more, check out Strategies For Quarterly Earnings Season.)
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1. It's All Relative … to Expectations
Earnings season is when individual investors get a reminder of just how thoroughly the short-termism of Wall Street has infiltrated the markets. A company can report a devastatingly bad quarter and professional investors will cheer so long as it was 2 cents less devastating than commonly expected. Likewise, a company can report a spotless quarter and excellent growth, but coming in a penny or two shy of the published number - or, even worse, the dreaded '"whisper number'" - and tumble.
Investors have only a limited set of options to deal with this reality. Investors who focus on momentum and short-term trading certainly need to know the range of estimates for a company before the earnings release, as well as the recent trajectory of those estimates. Longer-term investors arguably do not need to worry so much. Nobody likes to see any of their holdings dropping in price, but there is a big difference between price and value, and if an over-reaction to misguided expectations creates a gap between price and value, patient investors can step in and invest.
2. Tomorrow Is More Important Than Today
As much as professional investors obsess over performance relative to analyst expectations, they are often just as focused on a company's comments about future performance. A company can post excellent results - and beat the estimates for the quarter - but if management is cautious about guidance or trims its forward estimates, the stock can still take a beating.
It is entirely reasonable for an investor to be keenly interested in the future financial outlook for a company, and to revise expectations accordingly. What is not quite so reasonable is the timing and magnitude. Dumping a stock because management thinks the next quarter's earnings will be 30 cents instead of 31 is silly, but it happens all the time. For investors with a longer-term focus, though, this can actually be a gift - if your analysis says that the company's overall growth is on track, you can take advantage of this manufactured setbacks to build your position at a better price.
3. Go Past the Press Release
Investors who only content themselves with reading a company's earning press release run the risk of getting only part of the story - namely, the part that the company wants to emphasize. Although companies cannot legally lie in a press release, there is plenty of room for legal (if slimy) puffery and misdirection. Companies can focus on meaningless positives ("record earnings," "unprecedented opportunities") and ignore glaring problems in the numbers.
When it comes to the SEC, though, the company has to be more careful and informative. The company's 10-Q will include all of the relevant financial statements, including statements like cash flow that are often left out of press releases. The 10-Q can also contain information that the company '"neglected'" to mention in the press release - information about competitors, regulatory actions, manufacturing difficulties and so on. Smart investors, then, never forget to review the 10-Q for the real story on the quarter. (To learn more, see EDGAR: Investors' One-Stop-Shop For Company Filings.)
4. It's Just One Quarter
Last, and by no means least, one of the most important things for investors to keep in mind about earnings season is that it offers just a single snapshot on a company's performance. Successful investing often means long-term holdings of positions in quality companies. Overreacting to a single earnings report (or worse still, overreacting to the market's reaction to a single report) is a good way to shake yourself out of a good story over a temporary problem.
It is very important, though, to dig into the details and think about the sort of underperformance that is occurring. If a company misses by a wide margin and its rivals are doing fine, this may be the sort of bad news that leads to more bad news. If it is a minor miss, though, or if the entire sector is in a soft patch, it may be time to consider patience. Good companies have a way of quickly snapping themselves back to health, while inferior companies simply make excuses and empty promises - it does not take more than a couple of quarters to figure out which one is in your portfolio, and to take the appropriate action.
The Bottom Line
Earnings season gets a lot of coverage, but smart investors will keep it in its place. Don't let the media sway you from your investing plan. A snap decision, no matter how well intentioned, could mean you end up losing out. (Still new to investing? Check out our Investing 101 Tutorial for a step-by-step guide to getting started.)
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