|Forbes.com, Fall, 2014. This article was written with Jim Cahn, the Chief Investment Officer at Wealth Enhancement Group. It was part of a series of articles developed under an agreement with Forbes to work with a variety of contributors and assist them in delivering actionable investment ideas each week. The site forbes.com is one of the top 500 sites in the world with nearly 10 million subscribers and nearly 100 million page views a month.|
There’s undoubtedly a paradox about an investor intent on holding a company for 10-20 years following its performance in 90-day or quarterly increments. There are four main reason that “earnings season” should matter.
1. Post-Earnings Announcement Drift. While market theory suggests that new information is immediately reflected in stock prices, many stocks move higher on positive earnings announcements and then tend to keep moving higher over the following months. [For a detailed look at the phenomenon, see Post-Earnings Announcement Drift: Delayed Price Response or Risk Premium]. By contrast, stocks that report poor earnings tend to decline both at first and, again, over the next few months. The reality is that it often takes time for new information to be reflected in stock prices. So good news around earnings time can be a good time for investors to add, while bad news can be a good time to trim.
2. Public Disclosure of Information. Along with earnings press releases, there are regulatory filings and company conference calls which can provide important windows into the company’s workings. For long-term investors, this is an opportunity to make sure that assumptions made about a company still hold true.
Here’s the caveat: While the company is legally obliged to make certain information public, they have no requirement to publicize or promote it. Say you’ve bought a company because you think it has real potential to expand in emerging markets. If an analyst doesn’t bring up “emerging markets” on the quarterly call and a reporter doesn’t dig something up on it, you might not know to test your assumption that the company is doing well for the primary reason you bought it. The onus is on you to read the footnotes, and monitor any changes in language and then compare it what you were expecting to find.
The classic example of this is when Kodak, now Eastman Kodak started revealing how much money it spent on developing digital cameras. It would have taken some thought, but you may have come to the conclusion that the Kodak you bought (a camera company) was investing in becoming different (a digital company). That insight may have changed your feelings about whether or not you wanted to hold it for the long term.
3. Metrics. Each earnings season the company gives you a fresh number to plug into various formulas which are known to be tied to positive future performance. The short list of calculations you should be making include:
- Profitability. Robert Novy-Marx in his paper, The Other Side of Value: The Gross Profitability Premium, explains the importance of profitability measured by gross profits (revenues minus cost of goods/services sold) to assets. There are many other measures too, including book-to-market ratio, raw profitability (operating margin divided by assets), etc. Using profitability is also a good way to spot leaders in a pack.
- Growth Rate of Capital Expenditure. If ongoing capital expenditure is increasing at a fast rate, that is a signal to dig deeper.
- Dividend Payout Ratio: If the dividend payout ratio is creeping up over time, I may start to question my long-term vision of that company.
4. Earnings Season Is All Year. The fuss made over earnings season, when companies officially file quarterly (10-Q) and annual reports (10-K), is really just a reminder that you should be doing this kind of due diligence all year. In reality, items of significance can be filed at any time, namely 8-Ks which announce “major events that shareholders should know about.” If an 8-K is filed late on a Friday night, especially before a long holiday weekend, one can be virtually certain it contains something the company is trying to gloss over and bury the deluge of SEC filings.