Managing Risk During Earnings Season

 |  Includes: IBM, ISRG
by: Andrew Corn

Over the years I have posted about earnings several times.

Among my client list is a fund of funds which does not like earnings risk. As a longer-term investor, I usually do not mind if a company misses analyst estimates assuming it is continuing on its path forward increasing the big three: revenue, earnings and margins. It will usually recoup and grow its stock price over time, but not always within a quarter. Their idea of not taking earnings risk is simply to sell the entire position before earnings and simply buy it back the next day or week depending upon the news and stock performance.

The past few earnings seasons the market has grown less and less forgiving. The criteria for earnings announcements are increasing and the bar is higher. This especially holds true for higher profile companies and growth firms. Now, the market wants a company to beat for earnings, beat for revenue, and now announce increases in annual and next quarter estimates. It's not just increases. The increases have to be above analyst estimates, not just the company's own estimates. Firms that do not meet these criteria can get hammered within seconds of announcing earnings.

This is the risk that is defined by my client. This is the risk I need to consider each day during earnings season for all of my clients. Keep in mind that institutional clients are not taxable so turnover is not a consideration. Others will bring up transactions costs, but frankly at a penny or so per share, this has never been a real consideration.

The real consideration is a simple risk/reward equation. Every day I have firms in different sectors with the ultimate idiosyncratic risk, earnings. Why the ultimate? I do not use options so "cheap" insurance is not available within my investment process. Besides, as one hedges risk, opportunity is equally diminished.

Wednesday it was International Business Machines Corporation (NYSE:IBM) which lost 3.53% and Intuitive Surgical, Inc. (NASDAQ:ISRG) which rose 7.15% its day after earnings.

As reported on MarketWatch:

IBM said it earned $3.07 billion, or $2.61 a share, on revenue of $24.7 billion, compared with earnings of $2.86 billion, or $2.31 a share, on $24.6 billion in sales in the same period a year ago. Excluding one-time items, IBM would have earned $3.3 billion, or $2.78 a share.

Analysts surveyed by FactSet Research had forecast earnings of $2.66 a share on $24.8 billion in sales for the quarter ended March 31.

Among its main business areas, IBM said software sales rose 5% from a year ago, to $5.6 billion, but its services business, which makes up the majority of the IBM's revenue, rose just 1% to $14.6 billion. The company also said the value of its backlog of services contracts was down 2% from a year ago to $139 billion.

Hardware sales fell 7% to $3.7 billion.

IBM raised its earnings estimates for its entire fiscal year, and now expects to earn at least $14.27 a share, up from an earlier forecast of at least $14.16 a share.

Excluding one-time items, IBM raised its full-year profit forecast to at least $15 a share from $14.85 a share. Analysts had earlier estimated IBM would earn $14.93 a share for its fiscal year.

Intuitive Surgical ISRG posted a 38% jump in first-quarter profit to $144 million, or $3.50 a share, from $104 million, or $2.59 a share, in the same 2011 period. Sales rose 28% to $495 million. The report exceeded Wall Street's forecast for a profit of $3.15 a share on $477 million in sales, according to FactSet. Intuitive Surgical said it sold 140 da Vinci surgical systems during the quarter ended March 31. The 3-D technology system allows surgeons to operate while seated using robotic arms that probe a patient's body. They sell for $1.1 million to $2.3 million. This prompted a handful of analysts to raise their price targets on the stock. Intuitive Surgical also raised its 2012 view for revenue and procedures using the Da Vinci.

Both firms "beat and raised" which used to be the golden duo. However, IBM posted flat YOY revenues and the street also didn't like its revenue mix, versus ISRG which was more of a straight line pointing up. Of course, market cap and revenue can't be compared with these two firms, and my position size was actually over 4x for ISRG. This is based on growth rate, commitment to the sector and that I have been trimming IBM since February as its stock price growth rate slowed versus XLK, a primary hedge. ISRG has held a primary position within my healthcare book and continues to outperform XLV, its primary hedge.

There is no perfect hedge within equities for equities. Each hedge is imperfect and brings its own challenges. No stock can be shorted to protect against another stock's earnings. Not within a sector, industry or supply chain. Each day brings new risks which are magnified during the season. Position size, selling into earnings, the number of positions within the sector and industry are all calculations within a portfolio's risk profile. Earnings season is exciting. The key is to calculate when it is optimal to maintain, reduce or increase your risk profile.

Disclosure: Mr. Corn is CIO of E5A Funds LLC and through investment strategies under his supervision, he is long both IBM and ISRG.