By: Jonathan A. Parker
At ACTP, LLP and underthehEDGE.com we strive to educate our partners and teach the general public some information that they may not know. This brings value to the community and allows the public an opportunity to see inside the mind of one hedge fund manager. To date we have posted “Gold’s Top at 1900” (which gold is currently trading at $1636 an oz.), Amazon short theory at $230 (which Amazon is currently trading down to $224) and HP Long Theory at $23 a share (which HPQ is currently trading at $24.88). In this piece we wanted to touch base on earnings season, how to profit from over reactions and seeking some good opportunities.
First, it is important to understand that earnings season is the period of time during which a large number of publicly traded companies release their quarterly earning reports. In general, each earnings season begins one or two weeks after the last month of each quarter. In other words, look for the majority of public companies to release their earnings in early to mid-January, April, July and October. It is important to note that not all companies report during earnings season because the exact date of an earnings release depends on when the given company's quarter ends. It is not uncommon to find companies reporting between the traditional earnings seasons.
Let me set up a live trade that we currently have, and the math behind the thesis. The following figures are actual numbers in reference to Alcoa (NYSE:AA), which is set to report earnings on Tuesday. This will give you an example of a trade that we would do at Atlanta Capital in real time. On Friday, we took a position in AA, the first Dow Jones Industrial Average company to report, and we initiated this purchase at $9.57 a share. AA is expected to earn $.29 per share and most analysts believe that the stock will easily beat the number of $.29. So it would lead someone to believe that is it beats the number, then the stock will rise to $10.50 a share or higher, but not so fast.
There are three main components to look at in this scenario. First is the earnings per share, second is the overall revenues and finally the company’s outlook for the next quarter and year. So let’s say that AA comes out at $.36 a share, they beat the expected revenues and their guidance for the next quarter is good, then the current multiple (11.45X) will apply, plus the $.07 beat on earnings. That $.07 is multiplied by 4, giving you an additional $.28 times the current multiple of 11.45X earnings, which would lend you to an additional price of $3.26 a share increase over the next 4 quarters added to the current price of $9.57, giving you a target of $12.83 a share. Looks like a good and even deal, but if the guidance is off, the revenues miss the mark or the stock misses the $.29 a share, then the stock could sell off to $8.50 ranges.
Next, we went a step further and looked at possible ways we can hedge our AA position before the report. AA is an aluminum maker and is dependent on worldwide growth of economies, which has been slowing over the past quarter or so. So we placed three total trades in reference to this one report, this is also called a hedge. What we have done is place a bet that AA will rise after the report, but we have protected with two additional trades. If the economies are bad, and future growth isn’t going to be there in the report, then there will be two beneficiaries of decreased demand for AA goods and services. One is an uptick in dividend demand, such as utilities, a decrease in oil demand and all other Aluminum makers will sell off with AA based on this news. This is the trade as we have it set now-long position in AA at $9.57 a share, a short position in ACH at $11.58 (A Chinese Aluminum producer) and short WTI Oil at $82.47. So how will this trade work if AA beats and jumps up in price? AA will jump a buck or so, and ACH will increase, but not to the same level as AA, and Oil should tick up higher by a little bit. This means that we have protected the AA position, by hedging the trade and we will make money in either direction.
Last item for this blog is what do the analysts have to do with the stock value and what is the elusive whisper number? The analyst will wait for a company to report, then analyze the report, then either upgrade or downgrade a company based on the report. This usually happens the next day after the report, so how do you trade this? Let’s assume you want to buy Apple (NASDAQ:AAPL) at $370, but you know they report in a day or two, and you are afraid they will miss the number, you can wait for the report and be ready to act after the report. If AAPL heads down after the report, it is likely they will be downgraded the following day, and this will give you ample opportunity to own it. If you like AAPL at $370, you love it at $345 when it is beat down. So always wait for the report, then buy or sell in the days to follow the report.
Here is an interesting question; what happens if a stock beats on the earnings and revenues and still sells off hard after the report? Why is this? The truth is there is another number called the whisper number. The whisper number is based on a group of money managers that give their opinion on what a stock will earn. So let’s look at our AA example. The stock is set to earn $.29 a share, but the whisper is $.32 so AA really needs to beat earnings of $.32 for the stock to really take hold and move higher. Whisper numbers can kill a good stock rally and for rightful reasons. The money managers that manage millions of dollars can sink a stock on their own, and if they are expecting $.32 on AA’s earnings then they are likely to sell their AA position, thus the move downward begins.
I know that is a lot to rap your head around this week, but let me recap. Hedge your trades and investments, look to earnings season for opportunities, wait for the analyst to speak and know the whisper number before you press the buy or sell on your trading platform. As far as AA goes, this is our trade at Atlanta Capital: Short ACH at $11.58, Long AA at $9.57 and short OIL at $82.47; I will update the results next week. Trading equities is an art, science and a philosophical idea, so always embrace new ideas and as always, think different…..