When it comes to discerning the future direction of share prices, I can't emphasize enough the importance of earnings growth. Or, as my favorite mantra goes, "Stock prices ultimately follow earnings." Yet, a subscriber recently wrote in to accuse me of being overwhelmingly lopsided in my application of this golden rule of investing…
"You always focus on companies consistently earning more and more profits, which are poised for stock price appreciation. But how about focusing on some dogs – companies with declining earnings and, in turn, stock prices that are bound to hit the skids?" – Joe B.
Okay, guilty as charged. So today I'm going to rectify the situation. With earnings season upon us, I'm sharing three stock landmines that every investor should avoid. As you'll see, the odds point to each company dropping by double-digit margins in the blink of an eye. And the last thing we want is to be stuck holding any of them in our portfolios.
Heck, one could detonate as early as Thursday morning at 9:30 AM… Take heed!
A Recipe for Disaster
To identify the market's most dangerous stocks, I focus on four key criteria:
~ Extreme Volatility: What better place to start than companies with a penchant for dramatic price swings, right? Well, each quarter, Bespoke Investment Group compiles a list of the stocks in the S&P 1500 Index that react the most violently on their earnings report days. I'm talking about single-day price swings of over 10%.
~ Negative Price Trends: Because market trends tend to persist, the next element I hone in on is year-to-date performance. Specifically, the most volatile stocks that also happen to be down in price for the year. Why? Because if a stock is already under selling pressure, the trend is likely to persist. And there's no better trigger for the next big leg down than a bad earnings report. Speaking of which…
~ A History of Bad Earnings Surprises: Since a bad quarterly report stands to trigger a selloff, I focus on companies with track records of reporting worse-than-expected earnings. The bigger the disappointments, on average, the bigger the stock declines we can expect.
~ Souring Sentiment: Last, but not least, I screen for companies where analysts have dramatically lowered their earnings forecasts over the last 90 days. This seems obvious, but keep in mind that analysts seldom get it right… so if they're rapidly souring on a company's earnings prospects, chances are, they're too late to the game and too conservative. And the actual results stand to be even worse.
Add it all up, and we have the perfect screener for companies destined to disappoint. So without further ado, here are the three most dangerous stocks heading into earnings season…
Our Top Three Earnings Season Stinkers
- Stock Landmine #1: Crocs, Inc. (CROX):
I can't believe anyone still wears these ugly plastic shoes. But they must, as the company reported sales of more than $360 million last quarter. Nevertheless, the future looks bleak for the stock. First, in a strongly rising market, shares are down 5% this year. Second, over the last 90 days, analysts slashed their earnings per share forecasts by a hefty 50% – from $0.39 to $0.18. And that sharp revision is no accident, either.
On September 10, management lowered its guidance, citing weaker-than-expected sales in the Americas. But even after lowering guidance, I'm convinced that the company is still going to come up short this quarter.
While analysts still expect the company to report earnings per share of $0.18, that's the high end of the company's guidance. So unless there was some end-of-summer rush for ugly footwear, there's no chance the company puts up better-than-expected numbers. And consider that in the last quarter, Crocs missed expectations by 25%.
Bottom line: With an average one-day price change of 12.02% on earnings days, look out below when Crocs reports results on October 24.
- Stock Landmine #2: Gibraltar Industries, Inc. (ROCK):
Bank of America (BAC) might be bullish on the industrials sector, but Gibraltar is the exception. The company has significant customer concentration without long-term contracts, weak pricing power and sizeable foreign currency risk. Plus, with the stock already down 13% so far this year, analysts have chopped their earnings projections by 34% over the last 90 days.
The company is prone to missing expectations by a wide margin, too. Case in point: Two quarters ago, the company's earnings per share tumbled almost 70% below consensus estimates. To top it off, the stock averages a one-day price change of 10.3% on earnings report days.
Bottom line: An investment in ROCK is anything but rock solid. I wouldn't leave any of my hard-earned capital on the line when the company reports results on October 31.
- Stock Landmine #3: Ruby Tuesday, Inc. (RT):
I confess, I may be a tad biased against this dining chain. I had a bad experience a decade ago, and could never muster the courage to eat there again. However, aside from my hellish night of food poisoning, this isn't a revenge mission. There are strong, fundamental reasons to expect a disappointment when the company reports its results after the bell on Wednesday.
The stock is already down 4% on the year, and investors are reacting to the company's weak sales figures, which prompted analysts to cut their earnings per share forecasts over the last 90 days from a profit of $0.08 per share to a loss of $0.05. (Ouch!) Now consider that the company has missed expectations by an average of 17.5% over the last four quarters. That means it's likely to report bigger losses than analysts expect.
Bottom line: An average price swing of 10.8% on earnings report days makes this one stock we should promptly remove from our menu.
That's it for today. Hope my pessimism satisfies you, Joe!