The Earnings Season Hype is Overblown
I moved to Florida five years ago because I was tired of two things: Taxes and weather.
I hear some folks talk about how much they love winter and I can only suppose that these folks do not have to drive in snow and ice, shovel their driveways, walk their dog in freezing temperatures or any of the other activities I learned to despise while living in the Northeast.
Poets and fools gush about the onset of fall with the changing of the leaves, the first hint of crisp winter air dancing in the setting sun and other drivel.
When it comes to weather, I want two seasons: warm and hot.
There are two other seasons I enjoy.
One, of course, is baseball season but that’s a topic for another day.
The other is related to markets and investing: I love earnings seasons.
Four times a year companies report their earnings as required by the Securities Exchange Act of 1934. Executives usually add remarks about the business to these statements, and many companies these days host conference calls with analysts and investors to discuss the quarter.
It’s a great time of corporate transparency.
What was meant to be a periodic reporting of business conditions to the actual owners of the company has turned into a feeding frenzy for traders, as investors routinely trim or add billions of dollars of market value based on how a company did in a three-month period.
Trading earnings season has become a relatively widespread practice, and if you surf around the Internet investment sites in January, April, July, and October as the reports begin to come in you will see all sorts of headlines about how to “play” ABC Corporation’s upcoming earnings release.
The “play” usually involves some kind of short-term option trade to benefit from the upcoming news. The theory is that if the stock does better than Wall Street analysts expect the stock will jump higher and the call options will shoot higher. If they fall short of expectations the put options will soar in value.
While that may, in general, be true, let’s stop for a second and think about what you are actually doing when you trade earnings season: You are making a bet.
A bet based on your guess about how accurate the estimate of some Wall Street analyst is about a very short window of time in a corporation’s history.
Now, even if your guess about the guess is correct, you have to be right how the psychological soup that is the stock market will react to the event.
If you are using options to trade earnings season, you have another issue to face. You have to be right about your guess about the guess and how the market will react, and you have to have paid the correct price for the option.
I will spare you the heavy math of options pricing but even if you get everything else right and you pay too much for the option you can still lose money.
I know a lot of professional options traders and they use their supercomputing power to price the options and their whole mission during earnings season is to get you to pay too much when you buy options and get paid too little when you sell them. Thanks to the constant exhortation to “play” earnings season far too many get caught up in the excitement and do exactly that.
To me, earnings season is important for a few reasons.
First, the overreaction of earnings traders can often create opportunities to buy stocks I like at favorable price.
As an example, back in the second quarter of 2016, Daktronics, a manufacturer of electronic billboards and stadium displays like the one in Citi Field, reported earnings that were far short of Wall Street expectations. The stock was hammered, falling by more than 25% in a short period.
It was a great time to buy, and investors who took advantage of the sell-off have enjoyed gains of more than 50% from those lows.
I also like earnings season because of the conference calls and CEO comments. I confess that I read the transcripts rather than actually sit in on most calls, as I can read the transcript of a 1-hour call in about 15 minutes but I read a lot of them every earnings season.
The economists and analysts can sit in their ivory towers and issue predictions, but corporate executives have boots on the ground and they see how the economy is actually doing instead of what the computer models say it should be doing.
Earnings season can provide us a snapshot of what is going on with the companies that we own or are thinking about owning.
Earnings overreaction can provide excellent entry points that allow us to buy good companies at great prices.
We can learn a lot about the real world economy and spot trends in consumer behavior by listening to (or reading) the quarterly CEO conference calls.
Earnings season can provide opportunities and valuable information, but it does not provide the excellent trading opportunity that the hype might lead you to believe.
Written By Tim Melvin
As a 30-year veteran of the financial services and investment industry Tim Melvin served as a broker, advisor, and portfolio manager. He’s combined this nearly three decades of experience with a love of value investing in order to help investors worldwide to multiply profits and build their nest eggs. As an avid value investor, Tim...