By SA Marketplace :
Earnings season is kind of a big deal for the majority of investors. It's when all of Wall Street is dialed in - literally (on earnings calls) and figuratively - waiting with bated breath to hear quarterly results from companies they love (and the companies they love to hate). Whether earnings are a true reflection of how a company actually performed, or intricate sleights of hand orchestrated in boiler and board rooms is anyone's guess. Ask a handful of market watchers, and you'll get myriad theories - some scientific, others conspiracy. In any case, earnings season is anything but boring. Beat? Meet? Disappoint? It's all a lot of speculation and anticipation, until it isn't.
We asked four Marketplace authors whose services focus specifically on earnings to join the Roundtable and weigh in with their thoughts on earnings season; how earnings, analysts' forecasts and the news flow influence their own investment approaches; and what stocks they're watching this quarter.
Damon Verial , author of Exposing Earnings
Earnings Forecast Focus , author of Forecasting Earnings
Jeff Opdyke , author of Post Drift Trader
Tom Lloyd , author of Daily Index Beaters
Seeking Alpha : Every quarter, earnings season gets a lot of attention from investors. It's something like a report card for stocks, and the most consistent period of news for many companies. What is your approach to taking advantage of earnings season given how much market attention there already is, and how does your Marketplace service fit into this approach?
Damon Verial , author of Exposing Earnings: From fundamental investors to day traders, Exposing Earnings members quickly become accomplished earnings traders. One of the first steps in this process is dismissing the idea of "earnings season." Every day the market is open, we are presented with at least one good earnings trade.
Thus, we refuse the idea that earnings is only important once per quarter. The high ROI that comes with a correct earnings prediction can come every day if you dedicate yourself to daily analysis. For those traders who cannot watch the market 8 hours a day, earnings trades offer the ROI of day-trading but without the requirement of sitting in front of your computer all day; you can enter the trade at market close, coming back the next day to see your profits, as we do with Broadcom ( AVGO ) every year:
Earnings Forecast Focus , author of Forecasting Earnings: My approach centers around studying the company's fundamentals. One of the things that is extremely helpful is identifying a trend. Trends are very strong and very difficult to break - just look at IBM ( IBM ). But it's not just financial trends that I look at. Management tends to react in certain ways in a specific situation. Again, just look at IBM massaging EPS in order to minimize the negativity around the revenue trend. It is human to be predictable, although we all like to think we're not.
There are a lot of professionals looking at earnings. These professionals can all read financial statements as effortlessly as I can. So just focusing on fundamentals isn't enough to produce consistent predictions. So my biggest edge is that I have experience with sell-side. I worked at a very small buy-side firm on what is the equivalent of Wall Street in my country. Of course, it doesn't come close to matching Wall Street. In any case, it was a hub for everything investment-related. Buy-side, sell-side, research boutiques, traders and brokers, etc.
I got to know a lot of the sell-side and how they work at the events I visit. Often times, whether a company will miss or beat expectations is dependent on the sell-side and not company performance. Sell-side is interested in making money through fees. This is dependent on buy-side sentiment. For example, if a current sector or stock is out of favor with the buy-side, don't expect much positive commentary from the sell-side. In contrast, stocks that are in favor will get beatable or "conservative" estimate consensus because that directly contributes to their fees. This benefits everyone, from the buy-side to sell-side to management that has bonuses directly tied to stock prices.
Sell-side does not see anything wrong with this. All of the sell-side folks I know don't see anything wrong with this. A couple of months back, a French analyst got caught trading before releasing his own recommendations. Something most retail investors and those on the outside frown upon. His commentary was : "I truly didn't expect to land in front of the AMF with these operations. I really didn't think I was breaching market-abuse rules." (The AMF is the equivalent of the SEC in France.) Mind you, he made 28 such trades. It speaks volumes that he'd allow himself to be quoted stating the above. In some ways, you could call them out of touch. But it is just a completely different world from what most folks know.
There's a whole world business behind these recommendations and estimates. They're not just sitting at their desk working on Excel sheets all day. In fact, a minority of the time is spent on actually drafting analysis. Understanding the sell-side business model, which stocks are in favor, what stocks sell-side is likely to neglect and which management teams have good relations, is crucial.
So basically, I combine my standard expertise of reading financial statements with industry knowledge on the sell-side business model.
Jeff Opdyke , author of Post Drift Trader: I think I have a fairly unique approach to this. The vast bulk of Wall Street tries to guess at where earnings will come in - will a company meet, beat or disappoint - and investors lay their bets on what they think the outcome will be. But I spent 17 years at The Wall Street Journal. I know how the sausage is made on Wall Street. I know that:
Too many analysts construct models simply to get to whatever the numbers are that some company's executive team guides them toward).
Too many companies (i.e., most) manipulate their finances 100 ways to Sunday for goals we on the Street don't always know about.
Too many company C-suites are often not very good at seeing what's coming down the pike, which is why they miss their own expectations and shock Wall Street.
And too many companies (i.e., almost all) are guiding for lower results just so that can say they "beat" expectations as a way to keep their stock price elevated.
As such, I don't go into the earnings season thinking about who might beat, and where should I be invested for that event. I let the trade come to me as opposed to me chasing the trade. I wait to see which companies beat earnings, and then gauge how the Street responds to that. Based on a decade of historical data I've compiled for the S&P 500 and Nasdaq 100, I know based on those factors which stocks will continue to move, and over what timeframe, after the earnings report it released.
It's all based on research conducted by a professor at Rice University who was once one of my good sources at the WSJ. I took his research and applied it to quarterly earnings as they're reported, and when all the factors signal a trade, I make that trade in the options market to goose the returns I'm able to generate.
Tom Lloyd , author of Daily Index Beaters: At Daily Index Beaters we have a daily report on all the stocks in the S&P 500 and the Nasdaq 100. Every week we publish a daily report on the stocks that are reporting earnings for the week. In the report, we emulate what portfolio managers are doing. We rate each stock as a buy, hold or sell. We also show other buy, and sell signals that go into our overall rating of buy, hold and sell. This sub-set of signals includes a fundamental, technical and implied return buy/sell signal. Our "Stocks In Demand" (( SID )) system does all of this work for us and our subscribers. The system reads the fundamentals; it reads the chart; it reads what analysts are saying and shows buy and sell signals for each of these factors. Then our overall SID grade comes up with an overall buy, hold, and sell signal just like the portfolio manager.
Here is the list of stocks in our paper model portfolio showing our overall buy, hold and sell signal next to the numerical SID grade that goes from 0 to 100. The buy, hold and sell signal is based on the SID grade. Like the portfolio managers discussed above, this is the only thing you can do with a stock and we spell it out with our buy, hold and sell signal annotated to the SID grade. Notice that each of the stocks has our buy/hold signal.
If you are really ambitious and you want to see the underlying signals, we break out the fundamental, technical buy/sell signals. Also, we show our proprietary, implied return signal based on analyst targets and ratings. We want 10% or better for a buy signal in implied return.
Our daily earnings report puts you in the same seat before earnings as the professional portfolio manager. Like the portfolio manager, you know before earnings whether there is a buy, hold or sell signal. You are only looking for surprises, where these signals will change after earnings. Our "Earnings Week" report is not going to tell you what to do before earnings. It will prepare you to do what portfolio managers are going to do after earnings. The portfolio manager will confirm his buy/hold signal for stocks in his portfolio and you will do the same.
Some stocks will have a negative surprise and if these are in your portfolio, you now know you have a signal to delete them and replace them with stocks that have positive surprises. So during earnings week we are prepared to spot surprises. If a stock is positive on our list and comes out with bad earnings, you know what you have to do. Likewise, if a stock is negative on our list before earnings and has positive earnings surprise, you know what to do with that stock. And if you don't know what to do, our signals will show you what they think.
SA: Do you view each company earnings report for a given quarter in isolation, or do you see connections between companies that open up opportunities? In other words, how much do you look at a broader picture as compared to just zeroing in on a given company's number and report?
DV: The general flow of the market as well as industry and sector in which the ticker-of-interest resides is important in earnings trades; we generally want to go with the flow, as this improves the probability of being correct. The reports of other companies seem to be a focal point for many amateur earnings traders, and this is where our methods begin to differ: Nike's ( NKE ) earnings report, for example, does not have much impact on how we position ourselves for Lululemon ( LULU ) at earnings. Of course, the general pattern is that a rally in NKE can spill over into LULU, but we are not taking a position in LULU because of a thesis on NKE; moreover, that spillover is a mere drop in the bucket when compared to the movement on the actual earnings date for the ticker-of-interest. And I should mention that sometimes we will take an opposite position in another stock in the sector as a way of hedging.
EFF: It depends a lot on what the key performance indicators are that really drive sales and earnings. Some might argue that this is very industry-specific, and I would agree, but it is also very company-specific. So if there is a company-specific item that is going to drive earnings much much higher, like with First Solar ( FSLR ), there's no need for me to look at how the solar industry is doing.
Conversely, companies with larger revenues can't be easily increased. So when looking at these earnings, it is best practice to see how the competition is doing and how much of that is related to industry specific factors. The Telecom industry is a very good example of strong industry headwinds. It is crucial to incorporate that into my forecasts.
JO: In terms of trading, I only care about each company in isolation. The earnings results for that company, and the market's reaction to those results, tell me if we have a trade.
Still, I do look at earnings broadly to get a feel for what's going on. For instance, I've had more than a score of companies on my list of potential trades report this week… and not a single trade triggered. Companies are either missing expectations, or the market is not responding well to those that beat, even when they beat by a solid amount. There's a weird funkiness in the market right now, and I just wonder if investors are growing skittish about valuations and are using good results to take their profits… the buy-the-rumor/sell-the-news approach to investing.
TL: The key things we look for just before earnings are the analyst upgrades or downgrades and the supply or demand taking price up or down strongly before earnings. Analysts worry about their reputations and for them to come out just before earnings puts their reputation at risk. They don't take such risks needlessly. So we pay attention to what they say just before earnings. Also we watch strong price moves just before earnings. There are no secrets on Wall Street. If the earnings are good and analysts know about it, then it is going to appear in the price just before earnings. There are no secrets because of the amount of money spent to find out secrets and I am not talking about illegal insider information.
We let price tell us whether the earnings were good or bad. We watch what the analysts do after earnings. Earnings calls are very staged, but they add color to the financials. The analysts are busy trying to find esoteric details that will enable them to tweak their financial models to come up with better answers in forecasting the balance sheet and income statement. All of the data learned on the conference call is synthesized by analysts and portfolio managers and quickly seen in price movements. Later we may find out that analysts are downgrading their targets, although in egregious earnings situations the analysts react and announce upgrades or downgrades very quickly.
We allow the computer to do all the grunt work for us and come up with buy, hold and sell signals to emulate portfolio managers as they wait for earnings to be announced. We use these signals before earnings to prepare us for positive and negative surprises after earnings and to act after earnings. Sometimes we trade before earnings. Our Earnings Week report helps subscribers to do this. We still have to do our due diligence using all possible sources, such as SA articles, to confirm what our computer answers are saying.
Not all stories are in the numbers or the financial statements. Some stories are found in the charts. Many times we have buy and hold signals on stocks that have little or no implied return. It could be as simple as the fact that the stock is overvalued and price is ahead of itself. It could also be that the analysts are constantly being surprised by the earnings and their ratings and targets are lagging. Of course, the analysts can also be dead wrong. Nobody can predict the future and this is what they are trying to do. I don't know why small investors are surprised when an analyst is wrong. Portfolio managers are never surprised when an analyst is wrong about earnings, because they know it is impossible to predict the future. But the portfolio managers certainly appreciate the analysts' efforts to do the impossible and pay them very well for their research, even when they use it in a contrarian manner.
SA: What's one of the companies you're most excited to watch as a potential trade this quarter?
DV: Advanced Micro Devices ( AMD ). I have mentioned its trading potential in our Weekly Top 3 . Apple ( AAPL ) is always interesting, but I play it sparingly because it is one of the harder stocks on which to correctly predict earnings rallies and sell-offs. But my definitive answer for favorite earnings trades is one of the tickers in the small handful of stocks I have correctly predicted every quarter; so far, that list is AVGO, Ulta Salon ( ULTA ), and Facebook ( FB ).
EFF: One of the most exciting ones is really First Solar. First Solar is my highest conviction earnings beat of this quarter. The company is expected to report breakeven numbers, but Wall Street isn't accounting for the sale of a solar project. I believe that could add at least $0.70 in EPS, which is an enormous beat.
To be clear, these sales are part of the business model. So it isn't like this is a one-time boost from an asset sale. When we now look at the chart, it becomes a trickier trade. The stock has run up tremendously since the last quarter. Both as a result of an earnings beat and on broader industry tailwinds.
JO: I don't have a single company, because, as noted, I have a list of companies I have whittled down from the S&P and Nasdaq. And I only trade if all the parameters are met. That's not something I can gauge before the fact, so I don't go into an earnings season with any single company in mind.
That said, I was really disappointed with United Rentals (NYSE: URI ). It beat, but not by an amount that was significant enough to trigger a trade. I've traded URI on its earnings twice in last year, and generated returns of as much as 299%. I was looking forward to trading it again. Alas…
TL: Apple, a strong value stock, was hit by the XLK sell-off in price and had the same price pattern as the ETF as price went down. Now of course it is retracing that drop in price, which is completely predictable.
Apple is a key stock to the market and acts very much like the broader market. It is one we are watching closely this quarter. It is one of the stocks that had our buy on weakness signal triggered by a price selloff that only increased the implied return and value of this stock. Earnings are due on August 1, and our signals right now are a "hold" SID grade of 75 and an attractive implied return of 21% buy signal based on analyst targets and ratings. If Apple had a negative surprise, that would be key to the general market. Likewise, even if the earnings are good, any major downturn in the market in August or September will take Apple down regardless of value, just as the XLK sell-off recently took it down. Here is our proprietary chart showing both fundamental signals like implied return and technical signals like Demand/Supply. Our overall SID grade combines both technical and fundamental data.
Facebook is also another key stock we are watching, and it is in our paper model portfolio. Their earnings are due July 26th. Like Apple, this is a key stock we are watching for earnings. The market acts very similar to these two popular FANG stocks. A negative surprise would negatively affect the market. Facebook has our SID grade of 91 for our overall "buy" signal and an implied return of 15.3% buy signal. You can see these signals on the report below.
SA: What are the key things you watch for leading up to an earnings report -- are you studying the company fundamentals, looking at market action, historical trading, something else?
DV: In the space allotted, I cannot begin to explain my earnings prediction process. I have spent countless days building my earnings trading method and can only teach the resulting strategy through the multimedia setup provided in Exposing Earnings. We make weekly earnings trades, discussing the strategies in in-depth analyses; we look at the top 3 weekly earnings trades, using crucial filter criteria; we discuss popular tickers in the live chat; we issue earnings trade alerts when some of the important earnings signals flash on my watchlist…
Still, you can get a general idea of one of my processes through the free information I provide to non-subscribers - in my YouTube videos , for example.
EFF: My approach centers on company fundamentals. I'm looking at profits, trends, hedges and whatever else that is needed. I always start by figuring out the key performance indicators. What is going to move revenue? How are margins going to develop and what is impacting that? Do I need to adjust for hedges? How about currencies, or are we looking at non-GAAP estimates which exclude currency fluctuations? How is the sell-side thinking about this stock?
There really isn't a complete checklist that I tick off because there are almost always company-specific issues we have to deal with. Some earnings forecasts are very easy and some take an enormous amount of time.
When it comes to price action, my approach is simple and I only use it to try and gauge market reaction. I will never forecast a beat or miss based on what the stock price has done. When I look at a chart, I'm looking at two things:
1) Where was the price trading one day before the previous earnings release and where is it trading now?
2) Has recent price action been bullish or bearish? I establish this by checking if we can see clear trends.
For example, say stock XYZ has traded down to $4 from $6 when it missed earnings expectations and is now trading back at $6. If I am forecasting another earnings miss, I'd see that as a very actionable short because the market has "forgotten" the pain so to speak.
If the stock is instead trading at $2, I'll be a lot more cautious about opening a short and I'd want my forecast to clearly indicate a wide margin miss. I'd do a valuation to assess how wide the miss needs to be.
TL: In my work with professional portfolio managers, I can tell you that they pick stocks solely based on fundamentals. However, they do use technicals in various ways. Charts do tell you what buyers and sellers are doing to price. Portfolio managers have to buy on weakness and sell into strength. Obviously, charts can help them to do this. That is why we use chart reading signals in our work.
Recently, when there was a rotation out of technology stocks into financial stocks, selling created great weakness in the charts and technology stock prices. Our buy on weakness signals were immediately triggered for the highly rated technical stocks. This was a golden opportunity for portfolio managers to take advantage of stocks beaten down by ETF selling. Our demand/supply signal shown on the report above for each stock, enables us to buy on weakness. This is exactly what we did and put these great stocks with beaten down price into our paper model portfolio. These stocks have now recovered from that Index generated sell-off.
There is a place for charts in stock analysis and I am glad SA shows charts in the articles of its contributors. That is why we show these little demand/supply charts on our Earnings Week report. These 20-day charts show the buying and selling just before earnings, which is very important. If analysts receive improved guidance from companies before earnings, we will see the increased buying as analysts relay this improved guidance to portfolio managers. Likewise, the same is true for selling before earnings.
We use our system to pick stocks for our paper portfolios, both the one for investments and the one for trading. Of course, after our system picks the stocks, we have to do our due diligence before putting them into the portfolio. We use all the sources available on the internet, to check our buy, hold and sell signals. Naturally, we use the articles on SA for each stock picked by our SID system.
As you can see from our earnings report, our approach is to cover all of the Index stocks that are reporting earnings. Our signals for each stock give us great insight into the stocks and sectors that are undervalued, such as when the technology stocks sold off. The system identified the undervalued technology stocks that would bounce back quickly. It is noteworthy that the pattern of the XLK sell-off pattern on the chart is very similar to the price pattern of many of the individual stocks in the ETF. Since it was a sector sell-off by ETF like Index selling of all stocks in the ETF regardless of intrinsic value. With the stocks that had increased value after the sell-off, making them relatively cheap, it was no surprise to see the strong technology stocks bounce up back to where they were before the sector sell-off. Our signals identified which tech stocks would do this.
SA: Do you listen to conference calls or read transcripts? If so, how do you use that information?
DV: Earnings call transcripts are important for two reasons. First, they add new information to the public database, which is essential for a stock's valuation; the new information determines the direction of the earnings gap and carries implications for our gap trade: A chronic overreactor, for instance, will often pull back after an earnings up gap caused by novel public information. Second, studies have shown earnings call transcripts to carry information strongly correlated to the price action of the stock over the following month. I have written code, bundling it up into still-unnamed software, for the purpose of extracting from the earnings call the factors that allow for the prediction of said price action and can thus call up quick, accurate predictions of a stock's general directional drift, doing so immediately after the earnings call. This is an important tool for our post-earnings trades.
EFF: I usually read the transcripts if I'm only doing an earnings forecast. If I'm looking at a stock based on long-term fundamentals I might listen to conference calls to get a better sense of management. These conference calls provide tremendous amounts of valuable information. To illustrate this, perhaps a story on the start of my investing career.
Before I was a financial analyst, I tried technical analysis (( TA )) for a couple of months. I quit as TA could never answer "why" a stock moved and up until that time, I believed fundamental-based techniques couldn't either. That was the time I saw a biotech stock jump 50% in a day based on an FDA approval.
After that, I was convinced that we can definitely figure out why a stock moves at least some of the time. I focused my efforts on this little biotech company. I was convinced that one of the drugs had a high chance of making it through the second phase trial. The only problem I had was that I didn't want to purchase equity when constant cash burns were jeopardizing that investment. So I decided I would buy calls one month in advance of the news.
The only problem was that I had no clue when the news would arrive. At that time, I was still fresh and I hadn't been trained yet. If I had read the transcript, I would have known the exact month. I ended up missing out on a ten-bagger because of that. Since then, I never researched a company without looking at the transcript. Almost always, they contain something that the average retail investor does not know.
JO: Mine is all "black box" for lack of a less-trite term. I input the relevant data, and the algorithm tells me if there's a trade to be had or not. What management does or doesn't say isn't part of the recipe.
SA: How, if at all, do Wall Street analyst earnings forecasts fit into your earnings analysis process?
DV: Analysts are almost always wrong in a consistent direction (e.g., overestimating EPS), and thus their mistakes are easily rectified. Yet the bias continues… why? Analysts are often used by public companies as tools for managing expectations; those that do not play the game are suppressed, denied information, as I personally learned after attaining a degree of notoriety. But those consistent biases empower us earnings traders in a number of ways. Again, the space allotted for my answer is not enough for the entire theory, but suffice to say that these biases are part of the reason that the fulfillment of the equation, Real EPS > Expected EPS, does not necessitate a rally in 40% of the stocks reporting earnings. I cover this more in depth for Exposing Earnings subscribers.
EFF: Wall Street forecasts are the baseline and from that perspective, they could be regarded as central. Sometimes, I'll only look at Wall Street forecasts to see what they are expecting. Other times, I try to remodel their forecasts if I'm not sure whether I am being conservative enough or not.
JO: Well, they play a huge role to the degree that they determine if a company misses, matches or beats Wall Street's expectations. So that are, in essence, the goal post.
But I don't put great faith in the Street's army of analysts. I mean, Reg. D years ago pretty much made analysts little more than stenographers who talk to the companies they follow, take some notes, then build models to match the company's guidance. True, some analysts will go the extra mile and try to tweak results based on "channel checks" and what not. And there are some pretty good analysts covering some of the names like Apple and who have deep ties to production firms in Asia - and they do provide some value, though many of them are analysts writing for tech blogs rather than Wall Street. But by and large, the bulk of analysts are numerical stenographers. I only care what numbers they post to the degree that those numbers, cumulatively, represent the goal post some company is aiming for in my algorithm.
TL: In our system we weight very heavily what analysts are saying about a stock with their ratings and targets. Our proprietary implied return buy/sell signal is completely based on what the analysts are saying. We believe that the analysis of any stock has to start with what the analysts are saying. They are the experts on the stock. They are highly paid to know the company they are following. They have access to company insiders who give them guidance on earnings forecasts. Some stocks have 30 or more analysts following them. Analysts are paid anywhere from $300,000 to over $900,000 a year. Using 30 analysts at the bare minimum of $300,000 gives a total cost of their research of $9 million. Of course the analysts cover more than one stock, but nevertheless the value of their talent is, at minimum, $9 million and why ignore that kind of expensive research and talent?
My SA articles show how many analysts, out of the total covering the stock, have buy ratings and what the consensus 12-month target is in their research. Portfolio managers use these analysts to make their own decisions and I follow the example of the pros. Portfolio managers don't necessarily follow the recommendations of analysts, but they are well aware of the analysts' research and then the portfolio manager makes his own decision. They never ignore what the analysts are saying.
Sometimes they use analysts in a contrarian manner. There is the case of a portfolio manager who called in the Wall St. analysts and asked for the negative case against a company he was interested in and they gave it to him. He already had a positive view of the company from his analysis. When the analyst's negative case turned out to be weak, he bought the company. He used the analyst research in a contrarian way. Many portfolio managers use technical analysis in the same way to discover bargains and where the market is wrong in pricing a stock.
Where do you think stocks are headed this earnings season, and what factors and information do you pay attention to most when it comes to earnings? Let us know in the comments below.
And thanks again to our panelists. As a reminder, you can check out their work here:
Damon Verial , author of Exposing Earnings
Earnings Forecast Focus , author of Forecasting Earnings
Jeff Opdyke , author of Post Drift Trader
Tom Lloyd , author of Daily Index Beaters
Follow the SA Marketplace account above and below to keep up with what's happening in the Marketplace, including our regular interviews and roundtables and product updates. Authors are launching new services weekly, and a lot of exciting new ones are on the docket for the rest of summer, so stay tuned.
See also Chipotle: Getting The Right Price on seekingalpha.com