by Matthew Weinschenk, Contributing Editor
Tuesday, May 11, 2010: Issue #1257
I love earnings season.
In fact, it ranks among my favorite times of year, alongside Thanksgiving and the kickoff to the NFL season.
Unlike the others, though, the beauty of earnings season is that we get it four times a year.
And that means four chances to profit, using a simple “how to” method with the addition of Post-Earnings Drift, I’m going to show you…
The Importance of Earnings Season
Why do I get so amped up over earnings reports? The reason is simple…
Because earnings season tells you more than just the performance of individual companies.
Forget any of President Obama’s speeches… forget what the Fed says… forget BusinessWeek articles… and definitely forget the “expert” comments on CNBC.
When taken as a whole, earnings season means more than any of it. In terms of gauging the direction of the economy and stock market, it provides some of the only hard evidence of what’s really happening. (And I’ll take hard facts over Fed-speak every time.)
And the best news is that earnings season provides the trigger point for one of the most profitable and proven trades in the markets today – one you can make hundreds of times a year. Here’s how…
The Earnings Two-Step
The National Bureau of Economic Research (NBER) says the recession is over. And with stocks already priced accordingly, there’s no time to waste. Let’s start with the two primary steps…
- Step #1: Always Look Ahead
First, remember that the stock market is a forward-looking entity – one priced on expectations. In other words, stocks don’t move based on a change in earnings, they move based on a change in earnings expectations.
So the real goal isn’t trying to predict the future, but rather, finding errors in the crowd’s opinion of the market (expressed in terms of price).
These market inefficiencies allow for profitable opportunities. Question is: How do you find these anomalies?
- Step #2: Let the Analysts Do the Work for You
You could spend weeks analyzing companies, developing your own sales forecasts, cost projections and eventually, earnings predictions.
The thing is, though, you’ll likely have to wade through hundreds of companies before you find a single opportunity – i.e. a stock that the market has substantially mispriced. Keep in mind, too, that you’ll need to find dozens of stocks to be sure that one little mistake doesn’t wipe out your portfolio.
Sounds like a full-time job, doesn’t it? That’s because it is. In effect, you’d be running a simplified model that Wall Street’s big research firms use.
That’s not a practical approach for an individual.
That’s why I prefer to pair the search for anomalies with a market inefficiency called Post-Earnings Announcement Drift (PEAD). I believe it’s the most profitable concept in the markets. The efficacy of PEAD, based on a mountain of data, cannot be overstated.
Catching the Post-Earnings Announcement Drift
Let’s see how the Post-Earnings Announcement Drift works…
- Let’s say a company announces an earnings surprise… As you’d expect, the stock immediately jumps higher.
- But what most investors don’t realize is that the stock continues to drift in that direction. The biggest moves come within a week of the announcement. But the price will ultimately drift for another 30, 60 and 90 days thereafter.
This means you don’t need to predict the earnings announcement and buy the stock ahead of it. You can simply wait and buy the stock after the information hits the market.
Now, in an efficient market, this shouldn’t happen. Once a stock makes an earnings surprise, it should immediately move to a fair price.
But because stocks drift, that’s why it makes sense to wait until afterwards to place your buy order.
It’s almost like the company is waving a flag that says, “Buy me now!” Problem is, no one’s watching. (Except us!)
Why Earnings Expectations Hold the Key to Profits
Remember my first point – stocks are priced on earnings expectations.
If analysts expect a stock to earn $1 per share this quarter and it earns $1.50… then the earnings expectations for the following two quarters (and, in fact, the next five years after that) are probably wrong.
Analysts and institutions have to go back to the drawing board to re-evaluate their models. Once they get everything figured out, they start buying up the stocks with real future earnings potential. That buying drives the stock up and is what causes the sustained post-earnings drift.
A word of caution, though: Not every stock drifts.
Some stay flat. Some even go in the opposite direction. That’s why you need to use extra diligence, using about a dozen other data points, to isolate the stocks most likely to move – and move the most.
And there are a number of indicators that suggest which stocks will drift the most…
Which Stocks Will Enjoy a Post-Earnings Drift? Look for These Three Signs…
I’ve uncovered many indicators that identify which stocks are likely to drift the most.
For example, the percentage of shares owned by institutions, a stock’s market cap and earnings quality all play a role. But you can take a shortcut.
Look for companies that fulfill these three things in their earnings releases:
- An earnings surprise.
- A sales surprise.
- The company raises its own future earnings estimates.
That “triple play” could filter as many as 100 stocks or so every quarter (obviously subject to change) that are poised to profit.
The point is this: While other investors clamor for the next big prediction that they think will put them ahead of the market, just watch for a proven anomaly that gives you an advantage over market prognosticators and the heavy-hitting professionals.