The Efficient Market Hypothesis predicts that news events drive stock prices. In other words, stock prices nearly instantaneously react to new information entering the market.
Some of the biggest news events that drive the prices of individual stocks are earnings announcements. In the United States, companies announce their financial results every three months. Prior to the announcements, Wall Street analysts feverishly work on preparing their “earnings estimates.”
The average of these predictions is known as the “consensus earnings estimate” and is generally thought to be factored into the stock price by investors Public companies that outperform the consensus earnings estimate usually see their share prices go up, while those that fall below the consensus surprise the market negatively and generally see their stock prices go down.
For many hedge funds, investing essentially has become an earnings prediction game. These professional investors try to predict the direction of a company’s earnings announcements better than anyone else, knowing that if they are right, the market will move in their direction after the announcement. Of course, with so many analysts trying to outguess the market, forecasting actually becomes progressively difficult.
One of the things that makes it so hard is the fact that the market’s expectations are not always obvious. Sometimes if enough hedge funds are expecting an announcement far above the Wall Street consensus earnings estimate, a stock will actually go down if it only narrowly beats the consensus number. Of course, hedge funds do not tell the market what they are expecting, so it can be hard to guess exactly how a stock will react.
To predict earnings, Wall Street analysts use several techniques:
- Most analysts start with an in-depth financial model in Microsoft Excel. This model will usually contain every line item of a company’s financial statements over the past five to ten years.
- An analyst will develop his or her own views of how things will look in the future through a combination of extrapolating past trends, looking at how similar companies have been doing and talking extensively with company management to gain an edge in understanding the business.
- To refine these models, the analyst will likely conduct “channel checks” by calling on the distributors of a company’s products to see how well they are selling and talking to competitors to gauge how the pricing in an industry is holding up.
Some observers have cautioned that this kind of high-stakes earnings-game investing makes it very tempting to use inside information. It is illegal in the United States to trade stocks based on non-public knowledge of a company’s earnings (this would include things like being tipped off by a member of the management team before a company announces). In the past couple of years, several high-profile hedge funds have run afoul of these regulations and gotten into trouble with the Securities and Exchange Commission (SEC).
Use the earnings game to your advantage
It is generally difficult for the individual investor to successfully compete in the earnings prediction game. Wall Street analysts have too many informational advantages. One key to successful stock-picking at the individual level is to compete indirectly with Wall Street. In other words, do not try to beat the market professionals at their own game, but be strategic and take advantage of their weaknesses instead.
For instance, if you have a positive long-term view of a company and are looking to buy the stock for the long term, you may want to use a temporary fall in the price of the shares after an earnings miss as an opportunity to obtain a low price. Just make sure that nothing in the earnings announcement has changed your favorable long-term view.
Corporate earnings analysis is just one way for investors to look for stocks likely to yield considerable returns on investment. Additionally, both institutional and private investors will seek alternative methods of analyzing corporate operations to gain advantage in an extremely competitive market. Some of these methods disregard the traditional analysis of stock fundamentals and focus instead on statistical and technical analysis of historical data to identify trading trends that can be used for profitable investing
We will get into an extensive overview of both fundamental and technical analysis a bit later in this series of articles about stock trading formulas. In the next article, we will discuss momentum trading, which can be driven by a combination of fundamental and technical factors.
Billy Williams is a 25-year veteran trader and author. For a free strategy guide, “Fundamentals for the Aspiring Trader”, and to learn more about profitable trading, go to www.stockoptionsystem.com.