3 Earnings Season Must-Knows

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Alcoa's (NYSE: AA  ) quarterly results are an alarm clock for securities analysts. They're always announced earlier than they seem they should be; they signal the start of earnings season; and depending on how they go (since Alcoa is considered a big, bellwether industrial), they determine whether the market gets up on the right -- or the wrong -- side of bed.

This quarter, Alcoa kicked off earnings season on a very strong note, with revenue and earnings that both surpassed analyst expectations. Not coincidentally, the stock market has continued to surge since that initial earnings season report on Oct. 7.

Is that reason to be excited? Perhaps. But as you read through all of the reports, releases, conference calls, and filings for the companies you own or are interesting in owning this earnings season, there are three things you need to remember.

1. It's only one quarter ... and it's backward-looking
By definition, an earnings report is about what just happened, rather than about what will happen. So whether it's Alcoa outperforming expectations or VCA Antech (Nasdaq: WOOF  ) coming up short, always keep in mind that one quarter does not make or break a company.

Alcoa, for example, has very volatile input costs and output pricing. You need key insights into the aluminum market to forecast how Alcoa will fare down the road; valuing the company is not as simple as running these recent results out into perpetuity.

Similarly, with VCA Antech, if your investing thesis asserts that owners will continue to spend on their pets, and that VCA Antech remains well-positioned to consolidate independent animal hospitals across the country, then it's really not too important if a weak consumer environment dinged laboratory revenue this quarter. Provided you're right about the underlying thesis, VCA Antech should rebound.

This reality is also worth remembering when a stock you sold blows out its next report -- as Chipotle (NYSE: CMG  ) has, just weeks after our Million Dollar Portfolio team recommended selling it. While Chipotle's better-than 11% comps and 27.7% operating margin are evidence of incredible success this past quarter, our model suggests that the burrito slinger would have to sustain those levels for more than five years to justify the stock's current price tag, and conquer Europe with store openings in the process. Could Chipotle do just that? It's possible, but we don't believe the odds are in its favor. Investors, however, are excited today, and if you're thinking about jumping on the bandwagon, just remember that it's just one quarter ... and it's backward-looking.

2. The trend is your friend
Another key when it comes to analyzing earnings is to put them context -- but not just the year-over-year context most releases generally provide. What is the year-over-year-over-year trend? The year-over-year-over-year-over-year trend? How is the business doing year to date? What did this quarter and this year set the company up to achieve next quarter and next year?

In the case of Coca-Cola (NYSE: KO  ) , for example, analysts were pleasantly surprised this quarter by better-than-expected sales growth. However, we saw this coming at Million Dollar Portfolio, which is one of the reasons we bought shares a few months back. We saw faster-growing emerging-market sales gradually taking over more and more of the company's revenue pie over time. Once these sales got large enough, they would move the overall needle in a way that surprised the market. 

That's what happened this quarter, where 30% volume growth in Russia and 12% volume growth in China helped Coke post 5% total sales growth. We're up 15% this year in Coke as a result.

Always put earnings reports in the larger context. If you can identify a longer-term trend that the short-term focused market is missing, you may have found a low-risk way to make money.

3. Time is on your side
Most institutions and frequent traders will react to earnings reports faster than you ever could as an individual investor. Rather than rue that reality, take advantage of it.

For example, optical networking play Infinera (Nasdaq: INFN  ) , one of our largest Million Dollar Portfolio holdings, spooked investors this earnings season by projecting slower growth and less visibility into future orders from companies such as Level 3 Communications (Nasdaq: LVLT  ) in the company conference call. What happened as a result? Despite a strong third quarter, the stock dropped more than 30%.

Some of this was investors revising their models, and some was fundamentals-based, but a drop of this magnitude generally indicates that -- just as it was during the so-called flash-crash -- pre-programmed computers were selling as fast as they could, based on what was happening to Infinera's stock price.

The key here, though, was to take the time to analyze what management's statements might mean for Infinera's business. When we did that, we concluded that it really wasn't all that out of the ordinary for a widget-maker to see shorter order lead times in an economic environment when tech companies are hoarding cash and lack insight into the spending priorities of their customers. Does this mean Infinera won't get orders this year? Not necessarily; it just means it won't know about those orders months and months ahead of time. Yet Infinera continues to grow its market share, revenue, and cash flow -- traits that don't generally lead to a 30% drop in market value.

In the end, we think that if investors take some time to look at Infinera's results rather than react to its stock price, they will conclude that the company remains a compelling buy.

That's what you need to know
When it comes to earnings season, the only sure thing is that it will be volatile. But if you remember that it's just one backward-looking quarter, to put the results in context, and to take your time to make a decision, then you will have a leg up on the rest of the market.

That's how we tackle earnings season at Million Dollar Portfolio, and our ability to do those three things has helped us be opportunistic and beat the market by more than 5 percentage points with the $1 million we've been entrusted to manage by Fool co-founders David and Tom Gardner.

If you'd like to follow along in real-time as we invest that cash and buy and sell our favorite stocks before we do, our Million Dollar Portfolio is opening to new members for a limited time only. If you're interested in learning more, click here.

Tim Hanson is associate advisor of Million Dollar Portfolio covering international equities. He does not own shares of any company mentioned. Coca-Cola and VCA Antech are Motley Fool Inside Value recommendations. Chipotle Mexican Grill and Infinera are Motley Fool Rule Breakers choices. Chipotle Mexican Grill is a Motley Fool Hidden Gems pick. Coca-Cola is a Motley Fool Income Investorrecommendation. The Fool owns shares of Chipotle Mexican Grill, Coca-Cola, and Infinera. 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.

Read/Post Comments (6) | Recommend This Article (22)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On October 22, 2010, at 7:57 PM, mtracy9 wrote:

    "...our model suggests that the burrito slinger [Chipotle] would have to sustain those levels for more than five years to justify the stock's current price tag, and conquer Europe with store openings in the process."

    I don't know what valuation model you're using, but it obviously needs some revising.

  • Report this Comment On October 22, 2010, at 9:37 PM, TMFMmbop wrote:

    Why is that? Do you think CMG is worth $200 if it never grows again from here?

    Tim Hanson

  • Report this Comment On October 23, 2010, at 5:18 AM, mtracy9 wrote:

    Why is that? Do you think CMG is worth $200 if it never grows again from here?


    I cannot envision a possible scenario for why CMG will not continue to grow? I know about the failures of Boston Market and Krispy Kreme. But I also know that there is a huge market for good Mexican food at a good price, and that is what we have here with CMG.

  • Report this Comment On October 23, 2010, at 8:09 PM, LucWarm wrote:

    Song of the doomed; there were probably quite a few folks that couldn't imagine scenario's where Crispy Cream and Boston Market would not continue to grow.

  • Report this Comment On October 24, 2010, at 3:59 AM, mtracy9 wrote:

    Even if CMG's 33% earnings-per-share growth rate over the past 5 years was pared down to something like 20% over the next 5 years, that's still awesome growth. As for Krispy Kreme, its chief financial officer was caught engaging in accounting fraud, making sure that quarterly results beat Wall Street expectations by a penny or so. There's nothing fishy about CMG's financial reports. In fact, its CEO has tended to underestimate expected results, instead of hyping them.

  • Report this Comment On October 25, 2010, at 8:18 AM, scbtl wrote:

    I'm trying to figure out where CMG will go from here. What new markets are going to be explored by their management? Obviously their presence will expand in the US, but that should be slowing down, not speeding up. What emerging market are they going to break into? Ethnic prepared food, while it has a presence, is not expanding rapidly in Asia. How many restaurants would CMG need to open on a yearly basis to keep their growth that high? What effect will dilution and swaying public fads have on their sales?

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