US earnings - here we go again

It might feel like the dust has only just settled on last quarter's fun and games (remember the fireworks from companies like PayPal, DocuSign and Peleton), but this week sees the start of first quarter earnings season in the US.

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What lies ahead?

If you’re hoping for tips on how to make a quick buck, then look elsewhere. Gambling on earnings announcements is a fool's errand. Markets tend to be pretty good at pricing in potentially ‘good’ or ‘bad’ news in the short term. 

This means your odds of turning a trading profit on earnings news flow are no better than a spin of the roulette wheel.

That said, earnings season is an invaluable opportunity to take a good look under the hood of your portfolio. 

And so instead of trying to predict which stocks might go up or down after their releases, we think it’s a better idea to focus on extracting learnings from the results season as part of a broader investment process. 

Here are a few pointers for navigating earnings.

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It’s about expectations

Generally speaking, headline figures don’t matter all that much. Instead, it’s what’s expected by the market that’s in focus. Of course, over time it’s company performance that shapes expectations, and so it might seem a bit glib to say sales and profits don’t matter.

But the point is that a company can report very strong results, if the market expected them to be stronger, it won’t win any accolades. And the opposite is true, a glimmer of unexpected hope buried inside a shocking set of results could rouse investor sentiment.

Knowing how to read what the market is expecting is a challenge, but a good place to start is with the stock price itself. 

It’s generally safe to assume that if a stock has been rallying a lot, then the market is expecting good things. 

Then there is valuation. Stock prices that command rich valuations usually have good times accounted for within them. And cheap stocks are often cheap for a reason. 

Perhaps the best way to know what is priced into a stock is to observe its reaction to the announcement. This is no help after the event, of course, but investing is about the long term and learning how to read market expectations can be a useful tool.

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Results are backwards looking

By definition, last quarter’s results are backwards looking, and markets only really care about the future. 

While few companies go from superstars to flops in the space of a couple of quarters, and the most recent set of results can be a nice indication of how a company is performing, it’s what management says about upcoming results that matters the most.

Here again, expectations play their part. If the market is optimistic about a company’s future and management indicates all is not well, either via lowering profit targets or subtle commentary, then it’s likely investors will reappraise their expectations and the stock could take a hit.

A good idea is to listen to conference calls and how management responds to questions about the future. Most companies host conference calls on their investor relations websites and post transcripts after the event.

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The Wall Street game

It’s important to remember that while company management has a better idea of what is going on than most investors, it doesn’t have perfect foresight. Which makes any forward guidance just that, a guide. 

Companies also like nothing more than ‘beating and raising’, meaning management usually low-balls guidance at the start of the year in the hope of beating those targets and raising projections as the year progresses. 

Wall Street loves playing this game too. Analysts like to raise their own outlooks (anchored by the company’s forecasts) and in turn investors lap up stocks that experience consistent increases in earnings expectations.

So if a company issues guidance that looks underwhelming, pay attention to whether this is a classic case of conservative Wall Street gamesmanship, or if it’s a genuine cause for concern.

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Play the long game (not the Wall Street game)

Results and the conference calls that accompany them can be a helpful way for investors to build knowledge of a company, but they come with a lot of hype and headlines. 

Ultimately, one quarter’s results represent a single moment in a company’s entire history and future. And while an important indicator of the here and now, they rarely dictate long-term future success or failure. 

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