4 Rules to Follow This Earnings Season

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

Alcoa unofficially kicked off earnings season on Monday and traded flat for most of Tuesday after a mixed quarter. Now, we prepare for a volatile six weeks, as most of the S&P 500 will report their quarterly reports during this period.

While you may hold a stock that will rally 15% after reporting earnings, there will be many who are prepared to chase gains, buy before earnings, and will overreact to initial top and bottom line numbers. In this piece, with earnings season expected to be particularly unpredictable, I am giving you four rules to follow.

Rule #1 Read & Listen!

This might sound like common sense, but far too often retail investors get trapped with the initial volatility following earnings. But here’s the thing, sometimes the market will get it wrong, which will create value--or a value trap.

Therefore, the first and most important rule is to actually take the time to read the quarterly report. Then, after your initial impressions, listen to the conference call and the Q&A with analysts. This conference call will be very important, as the Q&A will be the basis for future upgrades and or downgrades.

Rule #2 Be Patient

If you follow Rule #1 then chances are you will be patient. Because after all, a stock may trade for hours before the conference call is complete.

There are countless good examples of why this is important; most recently you can look at Hi-Tech Pharmacal (NASDAQ: HITK). The healthcare company announced Q4 earnings before the market opened on Tuesday, missed on both the top and bottom line, and traded lower by 7.3% in the premarket.

However, its conference call began at 10:00 am ET, and its stock slowly begun to creep higher from $31.50 to over $35.00. The reason was because of the upbeat tone on the call, and the outlook that prices for its Fluticasone Propionate nasal spray product may be stabilizing. Also, additional details of a $15.5 million settlement that negatively affected its earnings were discussed.

The moral of the story: Use earnings to your advantage to capitalize on the initial, and often illogical, behavior. More times than not, the first 30 minutes of trade do not carry throughout the day.

Rule # 3 Seek “HOGs”

In my book Taking Charge With Value Investing (McGraw-Hill, 2013), as I lay out 20 rules for earnings, I discuss what I call “The HOG Effect”.

The HOG effect refers to an investment I made in Harley-Davidson (NYSE: HOG) back in 2011. Harley-Davidson announced earnings in October 2011 and traded lower by 7%, despite beating expectations.

Immediately, CNBC and others alike blamed the weak stock performance on inventories, yet the stock’s initial 7% loss was created when nothing was known except top and bottom line numbers. Turns out, shipments had increased 5.1% year-over-year, revenue rose 13.4%, and guidance for shipments was raised.

I bought the stock around $35, sold it for a near 40% gain, and was able to do this by identifying a strong quarter regardless of the stock’s initial reaction. During this upcoming earnings season, you will notice several HOG-like stocks.

These stocks typically do not trade higher the day of their report – it might take weeks or even months – but if the quarter is strong then buy and wait!

Rule #4 Roulette Is Ok “If”!

Do you like playing roulette, because when you buy prior to earnings you are playing roulette! During earnings season, a company can crush all expectations and trade lower, or trade higher after missing expectations. Therefore, it becomes a crapshoot, or a game of roulette at your local casino.

With that said, you don’t want to play roulette in the market and buy before earnings. Unless, you are buying stock in an industry that has provided consistent monthly updates. For example, the pharmacy and automotive space give monthly sales reports. A company such as this might be ok to purchase prior to earnings.

Personally, I have increased my position in Ford (NYSE: F) prior to earnings. The stock is sitting at 52-week highs and has done so with strong sales performance. In June, sales rose 14% year-over-year, including strong gains with trucks, and a 44% rise in China.

The auto industry appears to be clicking on all cylinders, and with guidance that is continuously upgraded, the risk of post-earnings volatility is diminished, making it worth the risk.

Final Thoughts

Personally, I couldn’t count five stocks (aside from clinical biotechnology) that I didn’t purchase after earnings. I always use earnings as an opportunity to capitalize on the irrational behavior of the market.

My Motley Fool CAPs picks, and score, has been accumulated due to my selections post earnings, as all were added following quarterly reports. These same stocks are those that I have added in my personal portfolio. Hence, there is a great deal of upside that can be created, but only if you have a plan and keep your emotions in check during the season.

The four steps above, are those that I feel are among the most important in the goal of creating gains – rules that I have used for many years -- and now they are yours to utilize. 

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Brian Nichols owns shares of Ford. The Motley Fool recommends Ford. The Motley Fool owns shares of Ford. 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. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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