3 Reasons Why Stocks Often Drop On Good Earnings

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Earnings season got underway in earnest this morning, with releases from three big banks, Citigroup (C), JP Morgan Chase (JPM) and Wells Fargo (WFC). Reports of Q1 2018 results will come thick and fast from hereon out and, by the time things start to slow down a few weeks from now, there will inevitably be some investors left scratching their heads. They will have watched as companies whose stocks they own report better than expected Earnings per Share (EPS), yet whose stock price will drop immediately after release. It usually happens for one of three reasons.

1. A Miss on Revenue:

Quarterly reports do not just detail earnings. They are complete financial statements, showing revenues, balance sheets, and other data. Corporations exist to make money, so obviously the profit and loss numbers are important, but when it comes to the immediate market they are less relevant than many people think.

An increase in profits does not necessarily mean that a company is growing. Margins can be increased by reducing costs -- either in terms of staff or investments in their business. If that is done as sales or other revenues are decreasing, it doesn’t bode well for the future, and the future has a large influence on stock prices. Traders essentially bet on where a stock will be tomorrow, next week or next year. A company who is making more money by cutting back rather than by growing is not an attractive investment and the stock will drop.

A revenue miss, even in the context of an EPS beat can therefore result in a sharp drop, but sometimes, even when the report beats expectations in terms of both profit and revenue, there can still be a decline. That is frustrating and puzzling to many investors, but there are other things to consider.

2. A Miss Elsewhere:

Because traders are betting on the future, anything that hints at slower than expected growth can cause a negative reaction, and earnings reports often detail other metrics that are seen as future indicators. The best example of that is in the social media space, where user growth is an important statistic. An increase in users doesn’t always translate to an increase in revenue or profits immediately, but it does increase the base of potential revenue sources. Slower than expected growth in metrics such as Monthly Active Users (MAUs) can therefore hit a stock in the industry hard, even if sales and profits look good.

Other industries also report relevant metrics that can prompt selling. For example, when an oil company reports disappointing production from individual wells or less land for future drilling than expected those things will override historical results. Or, in the case of a retailer, declining same store sales will have the same impact.

3. Forward Guidance:

The big daddy of causes for a seemingly illogical reaction to good earnings. Research has shown that forward guidance from management has the biggest influence on stock prices during earnings season. Once again, this is because it deals with the future rather than the past. Nobody is better placed to assess the prospects for a business than its executives, so if they issue an assessment of the next few months’ or years’ prospects that disappoint the market, the reaction is usually swift and sharp.

Negative forward guidance is even more impactful than other things as it usually has a knock-on effect. Traders and investors rely heavily on the opinions of Wall Street’s expert analysts when assessing a stock and their view is largely based on the guidance issued by companies. Once lower management guidance is factored into their calculations, cuts in their estimates follow. Each cut will itself prompt selling when published, so the effects of poor guidance can last for weeks.

An EPS beat followed by a drop in a stock that you own is frustrating, but it shouldn’t be mystifying. Nothing happens in financial markets without a reason, and understanding those reasons is essential if you are to make an informed decision on how to react to moves. When doing so, you should understand that a miss on earnings or elsewhere is factual but reversible, while lower than expected forward guidance is an opinion, but is more likely to have a lasting effect. With that in mind, you can logically assess the market reaction to earnings, and that should make the season less stressful and confusing.

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

This article appears in: Investing , Stocks , Earnings , Investing Ideas

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Martin Tillier

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