Active Trader: It's That Time of Year...Again

It’s earnings season again, that quarterly ritual when companies report their sales and profits for the preceding three months and investors act surprised -- or not -- at the results. Earnings announcements do move stocks, but investors must look beyond the headlines if they want to capitalize on any earnings-related volatility.

At their most basic, quarterly earnings provide a snapshot of how a publicly traded company performed in the preceding quarter. But when investors react to earnings, they’re reacting less to the actual numbers than to the expectations surrounding the numbers. The industry set the earnings bar pretty low for the first half of this year, based on concerns about the economy, and most companies beat their glum forecasts. But this time around, “expectations have clearly been elevated,” says Jeff Markunas, portfolio manager of the RidgeWorth Large Cap Core Equity Fund. Investors will want to see sales increases over last quarter, he notes.

While most of the headline earnings numbers will reflect the year-over-year change in a company’s profits —known as the “bottom line” and measured in earnings per share—many investors this quarter will be focusing on the “top line,” which represents revenue numbers. During the downturn, many companies have been keeping their profits high (or, at the least, higher than expected) by slashing their work forces and expenses-reducing measures. But “you can’t do that forever,” says Stephen McClellan, a former Wall Street analyst and author of "Full of Bull: Unscramble Wall Street Double Talk to Protect and Build Your Portfolio." “Sooner or later, you need sales.”

Wall Street analysts who follow companies make earnings forecasts based on their own models and the company’s “guidance.” A company that meets its earnings expectations is less likely to see stock fluctuations than one that surprises on the upside or the downside. A company might surpass its expectations but its stock still will slide if management indicates that next quarter doesn’t look nearly so rosy. Management offers forward projections in their earnings press release and also in their quarterly conference call to investors, which is open to the public. Analysts listen closely to the management’s message and also to executives’ tone, McClellan says: “Do they sound flakey, or do they have conviction?”

To trade around earnings, look for gaps between reality and perception, says Eric Marshall, manager of the Hodges Small Cap Fund. For example, he bought men’s retailer JoS A. Bank (JOSB) ahead of the company’s most recent earnings report, thinking analysts weren’t giving the company enough credit for holding up better than expected in the downturn. The purchase worked in his favor when the company’s earnings beat expectations and the stock rose.