Earnings Season Is a Time of Opportunity

Andrés is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Earnings season is already here, and this probably means higher volatility over the following weeks as Wall Street tends to overreact when it comes to buying or selling stocks after earnings announcements.  Higher uncertainty is an unpleasant thing to tolerate, but it’s also the kind of situation which creates buying opportunities for long term investors. In fact, this young earnings season has already provided some situations which look quite interesting.

Stock prices can fluctuate wildly after earnings figures are released, but that doesn´t mean the company’s value has changed in the same way. A company´s worth depends on the cash flows it will produce over several years, not on the figures for the last quarter. Because Wall Street and the financial media are usually too focused on the short term, investors with a long term mentality can benefit from short term volatility during earnings season.

The “official” earnings season starts with Alcoa (NYSE: AA), which reported better than expected earnings figures last week, but was actually sold off because the company gave a lackluster outlook for aluminum consumption. Alcoa delivered a small profit for the quarter versus negative figures expected by Wall Street analysts, so the company's restructuring efforts seem to be producing some results. However, Alcoa's management reduced its guidance for global aluminum consumption growth in 2012 from 7% to 6%, and the stock fell by more than 4% after the announcement.

The aluminum business is a very tough one. Demand is quite volatile and Alcoa has high fixed costs which make profit margins unstable and hard to predict. The company's earnings are clearly dependent on aluminum prices, so lower expected demand is a negative factor for Alcoa.

However, investors' reactions to the latest earnings announcement doesn't make any sense from a long term perspective. The company cannot affect global aluminum demand. What it can do, and has done during the last quarter, is try to keep costs as low as possible. Alcoa got punished for providing an uninspiring guidance about an economic variable it can't really control, and investors paid little attention the fact that the company is making progress on important fundamental aspects like lowering its cost structure.

Alcoa is a risky position. It has considerable exposure to the global business cycle, and the economic slowdown in China – a big aluminum importer – is a reason for concern.  But the stock is also very cheap trading at a price to free cash flow ratio around 5, and the market’s short sighted reaction to the latest earnings report just made the stock more attractive from a long term point of view.

Wells Fargo (NYSE: WFC) fell by more than 2.6% on Friday in another example of the kind of opportunities earnings season can provide. The bank reported earnings per share which were slightly above estimates -- $0.88 versus $0.873 estimated, a figure which represents strong growth of 22% over the same quarter in the previous year. However, investors were disappointed with lower than expected net interest margins.

Wells Fargo is growing both its deposits and loans, but deposits increased by a 3% while loans did it at a 2% versus the previous year. This means that the bank has more cash in its balance sheet, which is is not very helpful in terms of profitability, especially in time of historically low interest rates. As a result, Wells Fargo's net interest margin – margin from lending and investing -- fell by 25 basis points, which is more than the 17 basis points decline Chief Financial Officer Timothy Sloan anticipated a few weeks ago.

Lower profit margins are not good news, but they are caused to a considerable extent by the current economic environment. In fact, Wells Fargo has done much better in terms of profitability than competitors like Bank of America (NYSE: BAC), Citigroup (NYSE: C) and JPMorgan (NYSE: JPM) over the last years.

It’s not easy to run a bank in a scenario of weak economic growth and low interest rates, but Wells Fargo has produced better Return on Assets, Return on Equity and operating margins than any of its major peers over the last years.

<img src="/media/images/user_1532/roa_large.png" />

<img src="/media/images/user_1532/roe_large.png" />

<img src="/media/images/user_1532/op_margin_large.png" />

Even better, while its competitors are trying to streamline their operations and reduce their risk exposure, Wells Fargo is capitalizing its superior financial strength to increase market share and position itself for higher growth in the years ahead. The recent fall due to the earnings release may represent an interesting opportunity to buy this high quality financial institution at an attractive entry price.

Earnings season is usually full of noise and confusion, and stock prices tend to behave more erratically than we would like. This can be uncomfortable, but it also provides some interesting buying opportunities when short-sighted investors sell solid companies in knee jerk reactions to earnings announcements. Where some people only see volatility, the smart investor can find long term buying opportunities.

acardenal has no positions in the stocks mentioned above. The Motley Fool owns shares of Bank of America, Citigroup Inc , JPMorgan Chase & Co., and Wells Fargo & Company. Motley Fool newsletter services recommend Wells Fargo & Company. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.

blog comments powered by Disqus