The Art Of Successfully Playing Earnings

Includes: AA, CAT, GLW, HOG, NFLX
by: Brian Nichols

Two weeks ago I began a series of articles entitled "Stocks Worth Buying Before Earnings." The series consists of weekly articles where I choose stocks to outperform the market and trade higher following earning reports. For the last 5 years I have played earnings or bought stocks before a company would announce earnings. It took me a while to return consistent gains, but now I would say that it's a significant source of gains in my portfolio. I have had quarters where I've lost 20%, but I've had quarters where I've nearly doubled my investment. Because this quarter has began so well, there is now a significant amount of interest surrounding this strategy, and I have received many e-mails asking me to elaborate on this strategy of how I go about choosing stocks.

I have received several great questions. As a result I am writing this article, which highlights various strategies of how to play earnings, along with the do's and don'ts of playing earnings. This topic is very detailed and can be explained in much more detail than what this article provides. However, my goal is to offer the basics, and what I consider to be the most important strategies when playing earnings.


Buying Prior To Earnings --

My favorite strategy for playing earnings has always been to buy the stock prior to earnings. If done correctly, this strategy allows you to capitalize on volatility. If the company exceeds expectations, then it will hopefully trade much higher. This strategy is much riskier, but the potential rewards are much higher as well.

An example of buying a stock prior to earnings can be seen in the weekly articles mentioned above. Last week I chose Netflix (NASDAQ:NFLX) as one of the stocks to buy before earnings. I chose Netflix as a result of its value, low expectations, and its most recent gains, which indicate more bullish investors. There are several factors involved in choosing stocks prior to earnings, but the goal is to buy a stock that is presenting value, has low expectations, and enjoys investor optimism. This strategy is discussed throughout my weekly articles, which can serve as information on how to effectively choose stocks prior to quarterly results.

Buying After Earnings Are Announced --

Every so often a company will announce great earnings, but will trade lower. Most likely analysts will pick apart the earnings report and find one negative piece of speculative data and blame the loss on the data. But like Warren Buffett said, "There seems to be some perverse human characteristic that likes to make easy things difficult". This basically means that anytime something happens, we as investors have to find some significant reason to explain the action.

The market's daily activity is nothing more than a collection of investors, all playing with money, who are digesting and reacting to headline news. Sometimes investors will react to news that they don't understand, but will sell to avoid losing gains or additional loss. The theory of buying a stock after earnings are announced is based on the notion that investors are irrational and that when a fundamentally strong stock trades lower, it creates additional value. This theory will be explained in more detail in the do's and don'ts section, but below is an example of one stock that I hold as a result of this trend.

Back in October, I had chosen Harley Davidson (NYSE:HOG) as a stock to buy before earnings because of its strong growth and value presenting price. The company announced great earnings, yet traded much lower throughout the day following its earnings report. CNBC blamed the loss on inventories, but at the time, Harley Davidson was trading lower and all we knew was top and bottom line results. Therefore, I assumed it was a result of the market trading lower, consumer stocks being hit, and ultimately it was just a domino effect of investors attempting to prevent additional loss. As a result, I bought the stock, I still hold it today, and have returned 30% over the last three months as it appreciated very quickly after its initial drop.

Hold Long or Hold Short? --

Quite often I get asked, "when should I take profits?" and I always say "it depends on the stock and it depends on your goals." If a company posts great earnings and you buy either before or after earnings, then one of two events will occur. Either profit-taking will occur and the stock will trade back near its price before earnings or it will trade higher after its recent quarter dictates the trend of the stock over the next three months.

Harley Davidson is an example of a long-term buy following an earnings report because it's a stable company that is somewhat undervalued. However, Netflix is a company that reacts to every headline and therefore it's a short-term trade. I typically avoid long-term positions in companies such as Netflix and tend to initiate long-term holds in more stable companies such as Caterpillar (NYSE:CAT), another of my week two picks. Therefore, the decision on whether to hold long or short depends on the type of company you are buying and how volatile it trades on headline news.

Do's and Don'ts

The second part of this article provides more detail into the strategies that are listed above. After reading and reviewing the goals of the strategies, I'm sure several questions remain. This next part will answer several of the questions, and hopefully give a clear picture of what steps must be taken to increase your chances of success when playing the trends of earnings.

Buy Low & Sell High

If only buying low and selling high were as easy as it sounds! But unfortunately, it's never that simple. Because after all, you are actively trading in a market with millions of people who have their own goals and objectives. Unfortunately, there is no secret or guarantee that you are buying low and selling high.

Common sense tells us that when the market trades higher, people are buying. When the market rises we see gains and potential dollars and therefore we are more likely to buy rather than when the Dow Jones is down by 150 points. However, I believe that the most successful investors, especially when playing earnings, set rules for themselves to only buy when the market is trading with a loss and only sell when it's trading higher. This strategy is the only way to ensure that you are buying low and selling high, but unfortunately very few investors practice this simple strategy. I've been playing earnings for many years and I've noticed that I always return higher gains when I am buying a stock as the market trades with a loss then selling when the market trades higher.

Only Buy Companies That Consistently Beat Expectations

Buying stocks that consistently beat earnings expectations is similar to moving in a neighborhood with a very low crime rate. With a low crime rate you know that it has the possibility to worsen, but most likely the crime rate will stay low. I've never understood why people would gamble on companies that are inconsistent with earnings, it's similar to moving in a bad neighborhood but expecting it to change. It may change, but I'm not going to bet on it.

The neighborhood example is simply an analogy, and a bad one at that, but you get the point. It makes sense to purchase companies with a stellar history that consistently perform. Because although a company such as Alcoa (NYSE:AA) or Corning (NYSE:GLW) may show all indications of having a good quarter, I'm not going to believe it until it happens.

Only Invest Small Portions

Anyone who's read my weekly earning stock picks knows that I start at week one, with a set amount, and then I use the money throughout earnings season, with nothing more. For example, this current quarter, I began with $20,000, and then I invest the money into various stocks per week. If I lose $5,000 the first week then I only have $15,000 for the second week. The point is to not get yourself into a hole, or start taking from other long-term investments to cover a loss. My belief is that if you purchase enough solid companies with strong growth then it will almost always return decent gains after a period of 4-6 weeks. Yet regardless, you should only invest a small percentage of your portfolio in earnings, between 5-10% of your total holdings, maybe less.

Spread It Out

If you have a portfolio valued at $50,000, then chances are you're not going to invest the entire amount in one stock. The same concept exists when playing stocks during earnings. For example, each week when I purchase stocks before earnings, I try and purchase between four and six different companies that I believe are significantly growing while presenting value. This strategy can be difficult for even the most disciplined investors. Although I've been buying stocks before earnings for several years, I too sometimes fall into the trap of a stock that I believe is a "can't miss opportunity."

My most recent experience with a "can't miss" stock was in week one of my current series on buying stocks before earnings, with Google (NASDAQ:GOOG). I looked at all the facts surrounding Google and believed that it was a guaranteed gain following earnings. As a result, I initiated a large position in the stock, during week one, and was quickly reminded of my rules once the company missed expectations. The loss I returned from my trade of Google caused the week to return a loss, but it could have been prevented if I would have simply remembered my own rules and decreased my position. However, on occasion, the temptation is simply too great, you just have to remember the potential loss if the company were to miss.

Avoid The Downtrend

It's common sense that you want to avoid a downtrend because no one wants to return a loss. However, there is a significant correlation between the perception of investors prior to earnings and the reaction after earnings are announced. For example, look at Netflix and Travelzoo (NASDAQ:TZOO) which are two stocks that have been negatively affected over the last 6 months by losing more than 50% of their value. Both companies have posted record fundamentals.

I rarely see a stock that is trading in a steep downtrend post earnings and trade higher. The chances of a company reversing its trend are very slim following earnings. However once the stock bottoms, then it may present value. This was evident in shares of Netflix after posting its last two quarterly results when it traded much lower after Q3 but higher after Q4. When the company announced Q3 results, it had bottomed but was still trading in a downtrend. But since it announced Q4, the stock has traded higher by 35% YTD. I'm not saying the stock has to be trading higher for it to post large gains following earnings, but I am saying that it shouldn't be in a significant downtrend either.

Don't Be Greedy

I often say when talking about playing earnings that "it's a marathon not a sprint" which simply means don't try and hit the homerun with one stock- it requires too much risk. I play earnings for approximately 16 weeks out of the year and one of the biggest problems that I used to encounter was the results of my own greed. I used to avoid the profit, not because I didn't want to return gains, but because I wanted larger gains.

One of the best tools for an investor to use while playing earnings is a stop-loss and limit order through your online brokerage account. Anytime I purchase a stock, regardless if it's earnings or not, I will immediately set a limit order. It may take a week, month, or a year but eventually if you're buying for value then it will be executed. With earnings I use both a stop-loss and a limit order to sell the stock at two different points. The goal is to sell half of the investment once it appreciates, and then hold the other half to see if it rises even more.

For example, when I bought Caterpillar in week two, I set a limit order for $113.50 and a stop-loss for $111.30. The goal was to take profits when the stock opened, which could have been its highest point, and then hold the other half in case it trades higher throughout the day, or during the next day. But since the stock then fell, both orders were executed and the average price was $112.40. With Netflix, the first execution was at $113.25 when the stock opened, but the stop-loss price was never executed. Therefore, I was able to wait and sell the stock the next day for $120.59, for an average sell price of $116.92. The goal of using two separate sell prices is to ensure that you actually take profits. In my opinion, all investors are greedy, which is why taking the emotion out of selling the stock with different sell orders is usually your best bet, otherwise you may wait for larger gains and end up losing significant gains.

The only way to become very successful at trading stocks after earnings is to practice. You don't have to use a large amount of money to be successful. When I first started I used $5,000, and if you're interested I suggest starting with a similar amount. Then as you gain experience, you can add more in future quarters.

This article was written after receiving many requests, but the truth is that I could probably write a book on all the psychological factors involved in trading stocks during earnings. However, the key points that I've discussed are what I believe are most crucial to having success while playing earnings.

Disclosure: I am long HOG, CAT.