The Hunt for (Green) October

Earnings season is on fire. Even with Alcoa’s (AA) less than spectacular earnings report (in fact, it was quite the upset, with them missing earnings-per-share (AKA earnings, or EPS) estimates by nearly 6%), earnings season has been more or less a blessing to investors. In fact, 78% of companies in the S&P 500 have beat their consensus earnings estimates. However, investors are wary to mail in the win just yet. For the past five consecutive quarters, the S&P 500 has seen an overall decline in year-over-year earnings which, if the trend continues, it would be the first time since 2008, when they first started analyzing the index’s earnings. So the hunt for positive earnings reports continues, but in order to find them, one should start by understanding what earnings season is, and why investors pay such close attention to it.

First off, “earnings season” doesn’t actually exist. The term is just another one of those fancy names likely thought up by an obnoxious trader on some firm’s floor; and, just like every other random term, it stuck. Earnings season refers to the period during which most publicly-traded companies release their quarterly earnings reports. The “season” is seen as beginning when Alcoa, a large aluminum manufacturer that is listed in the Dow Jones Industrial Average, reports it’s earnings in the second week of the month after a quarter’s end. Earnings season ends after about six weeks, when most major companies have made their releases.

These reports detail important accounting items, such as net income, sales, and earnings-per-share, which serve as key metrics for investors to analyze their profitability. Earnings-per-share is widely regarded as the most important number to be released in this report, as it is the most quoted indicator of financial performance, and measures the company’s net income (less preferred dividends) as distributed over its number of shares outstanding. Put another way, imagine Apple, who releases tomorrow, reports an EPS of $1.66 (as currently expected). That means that, if Apple wanted to, they could pay out $1.66 for each and everyone of their 5.38 billion shares outstanding.

Earnings-per-share allows investors to compare the profitability of different-sized companies against each other (and themselves), giving a better picture of how each company is doing than by just looking at the plain earnings dollar. However, an investor must be aware that these numbers can be distorted. As with most metrics, EPS comes in many different flavors, including: Ongoing EPS, Diluted EPS, and Headline EPS, which may all be different based on the accounting item used to calculate the ratio.

Ongoing EPS is a measure of “normal” net income, or net income that excludes any unusual, one-time occurrences. Those occurrences might be the sale of a subsidiary (leading to a higher net income and higher EPS) or an unusual court fine (resulting in a lower EPS). Diluted EPS uses a more conservative, and accurate, shares outstanding number than basic EPS by taking into account all of the warrants, options, and convertible bonds were exercised. Each of those securities (as well as others) lead to an increase in shares outstanding, thus diluting (lowering the concentration of) the earnings across more shares of stock. Therefore, investors get a better picture of what the earnings payout per share would be if the true number of public shares were outstanding. To reference a previous article, Headline EPS can be considered a form of headline risk for a company. Headline EPS is the number that is used in a company’s press release and reported by the various media outlets. This number is misleading as it could be a company’s basic EPS, which is greater than, or equal to, its more conservative diluted EPS, and could show a significant increase in EPS that didn’t really occur. The other issue that might arise from different EPS measures used as Headline EPS is that different companies in the same sector and industry may use different EPS. For example, Microsoft may highlight Diluted EPS, while Apple highlights basic EPS, leading investors to believe that Apple was more profitable.

So what is an investor to do during earnings season in order to maximize profits? Well, provided one is willing to take-on the risk of an earnings play, there are two possible scenarios: (1) invest in a company prior to their report in order to get ahead of the momentum, or (2), invest in a company after their report and ride the wave. The first option is the most research intensive of the two, as it requires one to make their own assumptions about the earnings report against the overall context of the company’s financial health. Reading the reports from the last three quarters, as well as the most recent annual report, reading recent news headlines, analyzing their industry, and all of the other exciting things that analysts do in order to reach their assumptions. Similarly, one can go the easy route and look at the earnings expectations that have already been published and decide which one is the most trustworthy.

The flip-side to this would be to take advantage of the post-earnings announcement drift, which says that an earnings surprise (that is, a deviation from the expected earnings) will continue to effect the stock price for several days, or even weeks. To return to Apple, let’s assume that they release EPS of $1.72 instead of the consensus estimate of $1.66. This will excite people about Apple’s profitability, leading them to buy in droves, thus driving up the stock price. The effect will continue as people see the upward trend and buy-in over the coming days and weeks. As a savvy investor, one could buy as soon as a positive surprise is announced and ride the wave until the price begins to stabilize after the excitement fades.

Amid all of the investment strategies for earnings, there is one relationship that is a bit disconcerting: the gap between share price and forward 12-month EPS. In a report by FactSet released last week, they depicted the graph below of the S&P 500’s EPS against its pric, which showed an increasing gap between the two metrics, with price trending higher and higher. This means that the  companies in the S&P 500 have been trading at an increasingly higher multiple of their earnings since mid-2013, or that even though their earnings have been mostly flat, the price has had a significant increase. To put it even more simply: companies in the S&P 500 are becoming more expensive without their value increasing (as measured by EPS). This may be a sign that companies are becoming overvalued (cue the spooky music).

eps-v-price

All in all, with earnings season upon us, there are many tools that an investor has at their disposal in order to make the most of the increased trading volume. The key, however, is to make sure that one thinks for themselves instead of blindly following the pack. With many different ways to represent a single metric, and plenty of groups pointing people in different directions, it’s increasingly important to find elegance in the chaos.

 

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