Three Things To Keep in Mind During Earnings Season
The Larry Bird School of Sports Communication
The Shark (Qihoo 360) vs. The Whale (Baidu)
---
Earnings season is the name given to the period after the end
of a calendar quarter when many companies let everyone know how
they've been doing in the past three months. During the three
earnings seasons that begin in April, July and October, public
companies must each file a Form 10-Q with the Securities and
Exchange Commission, detailing their sales, cash flow, earnings
per share, expenses, cash on hand and other interesting numbers.
Quarterly reports are usually unaudited.
Starting in January, companies whose calendar year and fiscal
year are the same go through essentially the same process, but
they have to report for both the fourth quarter (Q4) and the
calendar year using a Form 10-K. (Firms whose fiscal year ends in
any other month have the same process, but different dates.) The
information required is more detailed than that required by a
10-Q, plus, it must be certified by an accredited auditing
firm.
The reading of quarterly and annual reports is a useful skill
for fundamental investors who want to do more than just kick the
tires on a company's financial health. (The catch is that really
deep analysis doesn't actually tell a growth investor anything
decisive; other factors will prove more decisive in the short run
than discounted free cash flows and balance sheet metrics.)
There are lots of companies that seem to find it easy to grow
revenues, and many of those can also increase earnings. For
people who care only about growth, those stocks always look
attractive.
But the equity world is intensely competitive, and investors
demand that management be growing their companies as fast as
possible to give them the maximum possible returns on their
capital.
The way this happens is that analysts (the people employed by
investment firms to follow particular stocks) issue estimates of
what they expect in revenue and earnings for the companies they
follow. Then services like First Call average those estimates to
come up with what's called a consensus estimate. And that
consensus becomes the target that stocks generally get rewarded
for hitting or punished for missing.
A company that barely hits its number will sometimes trigger a
smaller amount of selling, but nothing like the reaction to a
miss. A report that exceeds analysts' estimates is often called a
"beat," and one that does so by a wide margin often earns all
kinds of colorful language and a big jump in the stock's
price.
People in the investment community love the idea that they're
just a little bit more knowledgeable than the herd, so there's
also something called the "whisper number" that circulates on
websites and blogs. The whisper number is the number that
analysts might tell one another about while having drinks after
work, but won't publish. A stock that beats consensus but still
sells off a little is sometimes said to have "missed the whisper
number."
[Historical note: It used to be that companies would sometimes
selectively leak information about their quarterly prospects to
certain analysts, institutional investors, relatives and other
favored parties. This would produce a little buying or selling as
the insiders either got their bets down or took money off the
table, giving a hint to chart watchers of how earnings would turn
out. Even conference calls explaining quarterly results were open
only to brokers and institutional investors. But this all changed
on August 15, 2000, when Regulation FD (for "Fair Disclosure")
was put in place by the SEC. Under Reg FD, companies were
forbidden to give any information to anyone that they didn't give
to everyone. The SEC is quite vigilant in investigating
unexplained price changes in stocks before earnings are
announced. The outcome is that there really isn't any way to get
the inside track on earnings before the actual announcement.]
There are three big things you need to keep in mind about
quarterly reports.
First, volatility runs both ways. It certainly gives an
investor a nice warm feeling to look at a chart with an
earnings-fueled gap up. Here's a chart of Fusion-io (
FIO
) following its well-received earnings beat in August.
But you have to keep in mind that the downside is often even
steeper. Here's what happened to previous high-flier Green
Mountain Coffee Roasters (
GMCR
) in November. That's a haircut from 67 to 40 in one day!
So if you're thinking about buying into a promising stock so
you can get the big gains that come with a good earnings report,
you should ask yourself if you'd make that bet on the flip of a
coin, because that what a buy just before earnings amounts to.
Buyer beware.
Second, there are some companies that are able to beat
consensus, quarter after quarter and year after year. Sometimes
(as with Apple) this involves only a skill at controlling
expectations. Some CEOs are masters of implying that things are
slowing down, costs are rising and demand is squishy, when they
know all along that everything is just fine. When company
management gets a boatload of stock in their compensation
package, skill at handling analysts can be money in the bank.
But a look at a firm's earnings history will also reveal
companies that regularly beat what analysts expect. This is often
a result of management actions on the only numbers over which
they have control, which are costs. These companies are a better
bet for someone who wants to get in on the pre-earnings action;
at least their history suggests no major negative surprises.
Third, although many investors are daunted by a big gap-up
following earnings, Cabot's experience tells us that the energy a
stock gets from a big advance often continues to give the stock a
lift long after the announcement. So even if a stock has popped
up by 10% to 20% on earnings, you can still get good value from
buying in, assuming that the market's wind is at your back.
The reverse is true, too, of course. A stock that gaps down
after an earnings miss (especially if the trading volume on the
selloff is more than triples its average) will often just keep
declining. So the best choice when one of your stocks falls off
the end of the dock is to sell it and move on.
We hear some of the most imaginative and self-deceiving
comments from subscribers who want to know what they should do,
now that their stock is down 50% from where they bought it. The
excuses sometimes involve "waiting for the bounce" or "holding
for the long term."
The whole pageant of quarterly earnings is pretty artificial,
and often delivers deceptive results. There's nothing sacred
about what analysts think, and especially about an average of
what they think, without the supporting analysis.
But growth stocks frequently live or die by the numbers they
deliver. So it's definitely to your advantage to know when the
companies you own or have on your watch list are going to release
their news, and what you're going to do when they do.
---
The Circus Is Coming To Town: Earnings Season Is Upon Us
When my wife and I moved to New England back when the world
was young, the Boston Celtics were just beginning the Big Three
era, the period of NBA dominance for Larry Bird, Robert Parish
and Kevin McHale. It was all pretty exciting.
But while the basketball itself was riveting-especially Larry
Legend's mastery of the game and his long-running rivalry with
Magic Johnson-as a professor of public speaking, I got a special
kick out of what I called the Larry Bird School for Sports
Communication. It was as if Bird could turn on a river of
perfectly apt, but perfectly obvious, post-game comments for the
benefits of television interviewers … and just keep it up.
A sample might be: "It was a tough game and we have to give
lots of credit to [name of opposing team] they never gave up;
basketball is a team game, and this win was a team win and we all
had to pull together; we want to thank our fans, they're the best
in the world; we were lucky to pull this one out; our coaches are
great, they really had us prepared; we're going to have to play
better next time; [name of opposing star] is a great player and
it's always fun to play against him; my [name of injured body
part] was bothering me a little, but I just forgot about it as
the game went on; we had some trouble with the [court conditions,
refs, obnoxious fans], but that's just part of the game …" And so
on and so forth.
I've never heard anyone better at this underappreciated skill
than Bird, although some sportscasters come close in their
ability to spout meaningless blather to fill air time.
But I've thought a lot about how it might be possible to
develop a similar skill in talking about investments. After all,
as any long-time reader of CWA knows, investors of all kinds
almost always have a string of clichés and platitudes that they
can spit out at the right moment.
Here's what a little interview with an investment advisor
might sound like if he/she'd been to the Larry Bird School for
Investment Communication.
"Every [month, quarter, year, decade] in the market is tough;
With stocks so [high, low, volatile, under/overvalued] there are
no easy choices; don't try to catch a falling knife; if you think
it's a bottom, you're too early, if you know it's a bottom, it's
too late; nobody ever went broke taking a profit; bulls make
money, bears make money, pigs get slaughtered; the trend is your
friend; the only way to make a small fortune in the stock market
is to start with a big fortune; buy low, sell high; buy the
rumor, sell the news; don't fight the Fed; it's different this
time."
The funny thing is that a lot of what I write at Cabot, both
as editor of Cabot China & Emerging Markets Report and as
editor of Cabot Wealth Advisory, consists of either reworking one
of those market clichés or applying them to specific cases in a
sensible way.
There is, after all, a reason clichés are clichés. If there's
no truth in a truism, it usually just fades away. Only the best
can aspire to cliché status.
---
A battle between a minnow and a shark isn't much to get
excited about; the minnow just doesn't have the teeth. But a
battle between a shark and a whale, now that's the stuff of
legend.
The shark I have in mind is
Qihoo 360 Technology (
QIHU
)
, a Chinese mobile security company that also has a popular Web
browser. Qihoo is a small, lively company with a market cap of
$2.6 billion. This year, the company rolled out a new search
engine aimed at mobile browser customers.
The whale is
Baidu (
BIDU
)
, the dominant search engine provider in China, which has a
market cap of just over $40 billion plus (a few months ago) 80%
of the Chinese search market and 488,000 active online marketing
customers.
Despite Baidu's size and dominant position, Qihoo isn't an
ignorable competitor. Its 272 million monthly browser users are a
huge resource, and enough of them are already clicking the Qihoo
button on that browser (instead of the Baidu or Google buttons)
that both Baidu and Google have lost market share. Some estimates
are that Qihoo has taken a little under 10% of mobile search
traffic, with Baidu and Google both losing.
The dent in Baidu's market share showed up in BIDU's steep dip
in August, as well as QIHU's big rally.
There are lots of imponderables in this shark vs. whale
battle. The search quality is about the same for both Baidu and
Qihoo. Baidu has the resources to fight back by improving its
mobile product. Qihoo will need to put lots of money into
improving its ancillary services (maps, music service, etc.) if
it wants to take a bigger bite out of Baidu.
Right now, I'd say Qihoo 360 is a great candidate for your
watch list. The stock is tightening up its trading range as it
digests its August spring from 14 to 25. You can't count either
player out, but great conflicts make for interesting
investing.
Your guide to global investing,
Paul Goodwin
Editor of
Cabot Wealth Advisory
and
Cabot China & Emerging Markets Report