Source: Rafael Matsunaga, Flickr.
The latest earnings season has largely ended, with the vast majority of companies having issued their first-quarter financial reports to give investors an idea of how the businesses fared at the start of 2015. Yet as you reflect back on earnings season, it's important to recognize one of the big mistakes most investors make when it comes to assessing quarterly results.
Quarterly earnings and the art of dramatic overreactions
It's not unusual for stock prices to move sharply after earnings reports. A report that investors see as favorable can push shares dramatically higher, while missing the figures that investors had expected can be the kiss of death for a stock.
All too often, though, abrupt movements in share prices after earnings announcements are completely out of proportion with the actual importance of the results. A single penny of earnings per share can send short-term traders into a frenzy, with a miss provoking analyst downgrades and questions about a company's future, while a beat brings upgrades and irrational exuberance about business prospects and stock prices.
In context, though, it's natural to ask a simple question: Why can a single penny per share of earnings lead to moves of several dollars in the share price? It's true that current earnings can impact the growth path for future earnings, and so it's reasonable for an objective assessment of a company's value based on future earnings to move by several times the amount of the earnings miss or beat. But moves of several hundred times a penny-per-share disparity between expected earnings and actual results reveals many short-term-minded traders' obsession with quarterly results.
How to handle short-term-itis
Fortunately, these overreactions present opportunities for long-term investors. Here, a contrarian approach works well. When a stock plunges in response to a shortfall in net income, a huge drop in the share price can present a bargain. Conversely, if a stock soars based on unrealistic projections of better than expected growth far into the future, it can be a good time for investors to think twice about how much further shares can climb and potentially seek alternatives with better prospects for future gains.
Alternatively, if wild gyrations in share prices only serve to challenge your resolve, ignoring the reaction in the stock and focusing solely on what the quarterly report says is a valid way to maintain long-term discipline. Ignoring quarterly reports entirely can be a big mistake, as you might miss important trends that challenge your long-term investing thesis for owning the stock in the first place. Those trends typically appear over the course of years, though, not over a few months. If a company remains fundamentally healthy, then single quarters of poor performance will happen from time to time and don't necessarily create reasons to sell.
Earnings season is a good way to monitor how the companies you're invested in are doing. But don't fall prey to making decisions based on the resulting share-price movements. If you do, you'll often make emotionally driven decisions that you'll later regret.
