When a company reports earnings that are stronger (weaker) than expected, the stock price will often rise (fall) in reaction. As a result, analysts spend a lot of time trying to predict a company's upcoming quarterly results in advance of the actual release date. Unfortunately, predicting quarterly results has proven to be a very difficult task. But there is a better way.
While individual investors are not in a better position than analysts to predict short-term earnings, the good news is they don't have to. The market offers investors the opportunity to buy companies where bad news can't sink a stock as much as good news can buoy it. This is because such stocks offer investors a margin of safety; in other words, the bad news is already baked into the stock price.
As an example, consider Key Tronic (NASDAQ:KTCC), a stock we have previously discussed and a member of the Stock Ideas page. Last week, the company announced that 2nd quarter earnings per share would be closer to 12 cents rather than the earlier estimate of 3 cents. The next day, the shares closed 25% higher.
Of course, predicting the earnings surprise would have been impossible for the average investor, so let's consider what would have occurred had earnings disappointed. It is not likely that the stock would have fallen by the same dollar amount or the same percentage. This is because the company is profitable and has $60 million of current assets against total liabilities of $26 million (for a difference of $34 million) while the company traded for a grand total of just $25 million.
However, predicting the market's reaction is nearly impossible; it is entirely possible that an earnings disappointment of the same magnitude would have caused an equally negative reaction in this stock. Even in such a case, however, the stock would have become even cheaper, with further reduced downside and increased upside potential. Such was the case for many stocks in March, as the market decline took many stocks to levels where the downside was minimal and the upside potential was large.
Predicting earnings, and predicting the market's reaction to those earnings is a very difficult task indeed. Instead, investors should focus on buying businesses that trade at large discounts to their values. Such opportunities offer asymmetric returns: the downside risk is minimal, while the upside potential is high.
Disclosure: Author has a long position in shares of KTCC