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Earning Season's Here – It's Time to Find Some Losers

11 October 2013 in Trading Ideas

With Alcoa’s profit report this past Tuesday, the unofficial start to this quarter’s earnings-reporting season is upon us.

For many investors, it’ll be time to look at financial statements, balance sheets, and parse company conference-call transcripts for any little nuggets of information that could help future investment decisions.

For other investors, however, there’s just one question: Did you beat the Street?

Interestingly, as hedge fund manager David Einhorn recently noted with disdain, that feat has become increasingly commonplace. Specifically, Einhorn was referring to a growing tendency of companies to beat expectations for the current quarter, and then cutting their guidance for future periods – thus making it easier to beat the Street three months down the road.1

For Einhorn, the practice makes somewhat of a mockery of companies’ long track record of exceeding estimates. As a chart produced by the website Quartz shows, 71% of companies are expected to beat Wall Street earnings expectations this quarter, and that percentage hasn’t really changed significantly in the past four years.

So, what about the other 29%? If you can’t beat the Street in this day and age, does it mean you’re just not smart enough to play the game?

Not necessarily – in fact, isn’t it possible that companies that are able to take it on the chin immediately from investors may actually be showing a focus on longer-term value-enriching goals rather than putting resources into an exercise every 90 days in managing expectations?

Even more importantly, there are examples every quarter the punishment meted out by investors after a disappointing earnings report can prove to have been overdone.

disappointing the streetThat general premise is what’s behind our Disappointing the Street motif, which is up 2.9% in the past month and has gained 17.4% since its creation in March 2013. The S&P 500 is off 0.7% in the past month, and has risen 8.0% since the motif’s inception.

The motif uses a strategy that assumes, more often than not, that a stock-price decline that follows a negative surprise doesn’t necessarily track with the long-term valuation adjustment that is really warranted.

Long positions are entered in the motif with the expectation that price will recover. Of course, some negative surprises can be indications of fundamental reversals in a company’s operations. The motif attempts to hedge that risk by sticking with companies that have had active stock option issuance in recent years, and it avoids stocks that are testing recent price ranges.

The motif is rebalanced monthly and stocks are generally held for three rebalance periods.

For investors who tend to be attracted to stocks they still like despite suffering an earnings-season beatdown, this motif could be an alternative worth considering.

1John McDuling, “Five things to watch out for this earnings season,” Quartz, Oct. 8, 2013, http://qz.com/132658/five-things-to-watch-out-for-this-earnings-season/#132658/five-things-to-watch-out-for-this-earnings-season/.