Part 3 – Lesson 17
If an investor intends to remain an owner of a company for the long-term, the investor will have to hold their position through multiple quarterly earnings reports over time. Earnings reports can be associated with a lot of volatility that can spook new investors. The key to staying the course is conviction in your investment thesis.
If an investor has low conviction in their stock idea, taking quarterly earnings risk is generally a bad idea because if the stock moves against the investor, he/she will have limited conviction to buy more and may be tempted to cut their losses and run.
Assuming an investor has high conviction in their idea, an investor should be sure to listen to all the quarterly earnings calls and read the quarterly earnings report. The quarterly earnings press releases and webcasts can be found on the investor relations webpage of the company you are invested in (for example, search “Verizon investor relations” to find the Verizon IR homepage).
We ask ourselves the following questions in anticipation of holding investments through earnings:
Question 1 – Do I have a view on the quarterly earnings report?
Typically, we do not have a high conviction view that a company will beat or miss earnings for any specific quarter. In our experience, it is extremely difficult to predict quarterly earnings with any level of specificity. Even when investment analysts expend resources to speak with consultants and industry experts, there are just too many variables that create fluctuations in revenue and earnings in the near-term, which makes quarterly earnings extremely hard to predict.
Sometimes, we may feel that earnings estimates are directionally conservative, and the bar has been set at a low enough level that the company should be able to beat it. For example, if a company has been consistently growing revenue at 10% but sell-side is forecasting a slow-down to 5% despite no changes to company fundamentals, this would give us a bit of comfort that the revenue bar is not too difficult to beat.
If earnings estimates appear reasonable and we have high conviction in the long-term thesis, we may elect to modestly increase the size of the position. On the flip side, if earnings estimates appear aggressive but we have high conviction in the long-term thesis, we may elect to maintain the current position size or even modestly reduce position size in anticipation of stock weakness on earnings.
Any position re-sizing that we undertake based on our view of earnings is typically modest due to the high degree of uncertainty in predicting earnings.
Tip – Do not become over-confident on what you think will happen on earnings day and do not rely on others who claim to have confidence on what will happen next quarter!
Question 2 – What are investor expectations and how is investor sentiment for the quarter?
The movement of a stock price on earnings day will be a function of two factors: 1) actual results vs. expectations and 2) investor sentiment. For example, if Facebook investors are widely bullish on the next quarterly earnings report, it raises the bar as to what Facebook must report for the stock to go up. Often, a company may report seemingly positive results that meet or beat sell-side expectations, but since buy-side investors already expected a beat, the stock may trade down despite the earnings beat.
For example, let’s say that sell-side is forecasting 20% revenue growth for Google, but investors have a very bullish view on the quarter and are expecting 25% growth for the quarter. If Google reports 22% growth for the quarter, the stock may trade down since investors will be disappointed that it did not meet their very high expectations.
Long-term, it may not matter how near-term investor sentiment fluctuates, but it is important to understand sentiment so that a long-term investor can understand the stock price movements of their investments. A stock that reports great results but goes down due to an expectations miss is often a good buying opportunity.
Ahead of earnings, if we notice that investor sentiment is very positive on a stock, we may elect to modestly reduce position size due to the high bar that must be cleared. Conversely, if investor sentiment is very bearish on the quarterly earnings, we may elect to increase position size if we have a more positive outlook.
It is helpful to also look at how the stock has traded ahead of earnings to judge investor sentiment. Typically, a stock that trades up meaningfully into the earnings report is reflect of very positive investor sentiment.
Question 3 – After the earnings call, is the long-term investment thesis intact?
When all is said and done, we want to know if the outlook of the company has gotten better or worse. If the stock goes down because the earnings report was not great, then, earnings estimates will need to come down, so the stock should be down. However, our trading decision should be based on how the stock reacts relative to the change in earnings estimates. We like to follow the below decision tree:
Post earnings, long-term investment thesis now broken = Sell
Post earnings, long-term investment thesis intact = Buy, Hold, or Sell
Earnings estimates up (post-earnings) and stock not up as much as earnings = potentially increase position
Earnings estimates up and stock flat to down = potentially increase position
Earnings estimates up and stock up more than earnings = potentially reduce position
Earnings estimates down and stock up = potentially reduce position
Earnings estimates down and stock flat to down slightly = potentially reduce position
Earnings estimates down and stock down more than earnings = potentially increase position
In Part 3, Lesson 10, we discussed “constant multiple” analysis. Constant multiple analysis can help an investor to put some analytical framework around how to trade a stock post earnings.
For example, let’s assume that Microsoft reports great quarterly earnings. Following the earnings report, sell-side analysts increase their EPS estimate by 5% for 2019. If MSFT stock is unchanged following the report, this means that the valuation has gotten cheaper (due to the E going up in P/E). With a cheaper valuation, this could be a good reason to buy more of the stock.
However, if MSFT stock is up 10% but earnings estimates only increased 5%, then, the valuation multiple has expanded. An investor in MSFT may want to look at the higher valuation multiple to confirm that the multiple expansion is warranted. If not, it may be worthwhile to reduce the position.
Constant Multiple Analysis
Let’s assume that Company A has earnings of $2.00 for 2019. Following its 1Q 2019 earnings report, sell-side analysts move their earnings estimate for Company A to $2.25. Download the Part 3 Excel file here (Part 3 Download).
In the above chart, you can see that following the earnings report, the EPS estimate of $2.25 is 13% higher than what it was previously ($2.00). If Company A maintains its pre-earnings multiple of 15x earnings, then, the stock should go up by exactly 13%.
In practice, stock prices don’t always go up or down in lock step with how earnings estimates move, which provides the diligent investor with an opportunity to react appropriately.
For example, if Company A’s stock price were to only go up 5% despite the EPS increasing 13%, this could provide an opportunity to increase the position size before the stock has a chance to fully react. To do this, investors will try to predict how sell-side earnings estimates will change post-earnings and trade the stock before new estimates are officially published.
Conversely, if Company A’s stock price were to go up 20% even though earnings only went up 13%, this may be a reason to reduce the position size if the valuation multiple expansion is not warranted. However, this is a judgement call that should be made based on whether the long-term growth of the company has increased or not. If there has been a sustainable improvement in the growth or durability of earnings, then, the valuation multiple expansion could be warranted.
With all that said, many investors over-trade during earnings. As long as the long-term thesis is intact and the valuation implies that there is still plenty of upside, many investors will be best served by not over-thinking the near-term price movements and simply sticking to the long-term game plan.