Busting the Earnings Myth: The earnings cycle is one of the most volatile times in markets throughout the calendar year. In the case of these earnings reports which may seem positive at first – just remember that all that glistens isn’t always gold. And here’s why:
What are ‘Earnings’?
Earnings are quite simply a report to shareholders and the public of the company’s sales figures. Profit, loss, revenue, and everything else in between. This is where company reveals their balance sheets. And income statements over a period and provide outlooks on future growth and figures. Here in Australia, ASX list companies are legally require to report earnings every 6 months. Whereas, in the US, companies report every quarter. As host Andrew Baxter labels it – this is where companies provide ‘benchmark or waypoint’ for their performance over that given period.
The disconnect that exists with earnings
Quite frankly – when a company reports its earnings, it’s reporting figures on what has already happened. Contrary to this, the current share price of a stock is reflective of what is expected to happen – posing a large disconnect between the two. Expectations play a large role in influencing market prices. Especially, when it comes to the lead up before earnings. Often, we can see share prices rise in the lead up to their report as investors expect positive results, only to fall on the day as the numbers don’t match up to what they were hoping for. The opposite can naturally occur also. Largely, as host Andrew Baxter explains, expectations prior to the report are based primarily on a ‘consensus’ which is an average of all the analysts’ predictions released before the report. This is what investors use a proxy in the lead up to such times.
All that glistens isn’t always gold
Following on from the above paragraph. We can start to see the disconnect between the earnings numbers. And the share price in real life examples that have recently occurred. Let’s take US listed, tech giant Facebook for example (NYSE: FB) – Facebook has recently reported earnings in late January to which we saw the Earnings per Share (EPS) beat expectations by 20%, yet the share price fell 3% that day. Weird, right? A good local example is Temple and Webster (ASX: TPW) who which reported sales growth of nearly 120%. In their most recent report only to see their share price fall 4%. Another bizarre example was when Shopify (NAS: SHOP) reported earnings last year in 2020. And announced earnings that were nearly 60% above expectations. Yet again their share price suffered on the back of this.
The notion that good earnings equals a jump in share price is quite simply a myth. What these examples usually reflect are overinflated expectations of a company’s report that has already been factored into the price prior to the announcement day. When results fall short of expectations (despite being incredibly strong anyway). We see traders sell out of stocks causing price declines. A weird concept that is largely due to the behavior and cognitive biases of investors. As all that glistens really isn’t always gold.
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Traders vs. Investors on Earnings
The way earnings are play ultimately comes down to your objectives and risk profile. With this, we can sought out two distinct groups – traders and investors. When it comes to earnings for investors, given their large focus on overall company fundamentals and the broader economic environment – a drop in share price on good earnings really makes no material difference to their strategy. A trader, however, has the ability to pick these kinds of well-performing stocks up at a discount in such circumstances.
A pullback represents a great buying opportunity for the savvy, active investor who can start to overlay various strategies around this. As Andrew teaches throughout Australian Investment Education, strategies like RSI4 or a straddle can profit heavily from these kinds of price movements. Ultimately, it’s having an array of weaponry in the kitbag that will allow you to profit in such challenging market conditions as relying on old myths won’t serve you any benefit.