Earnings Season, The Final Jeopardy of Stock Investing

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Three Things To Keep in Mind During Earnings Season

The Larry Bird School of Sports Communication

The Shark (Qihoo 360) vs. The Whale (Baidu)

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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.

FIO Chart

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!

GMCR Chart

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.

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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.

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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



The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.



This article appears in: Investing , Stocks

Referenced Stocks: BIDU , FIO , GMCR , QIHU

Cabot Heritage Corporation

Cabot Heritage Corporation

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