The third quarter of 2016 is drawing to a close, and that means earnings season is right around the corner. If you own stocks for long enough, one of them is going to issue disappointing earnings results at one point or another -- it's just a mathematical certainty. Here's when bad earnings should make you nervous, and when you should ignore the noise and hold on tight.
Changes in the underlying business model could be cause for panic
Sean Williams: Generally speaking, earnings reports, regardless of how good or bad they are, aren't thesis-altering events. This would normally mean a bad earnings report isn't necessarily a good reason to head for the exit. However, if there's been a material change in the underlying business model of a company in your portfolio, it could have a direct impact on your investing thesis.
For example, following its first-quarter earnings report, retailer Nordstrom (NYSE:JWN) plunged as much as 16% after missing Wall Street's revenue estimates by $30 million and EPS estimates by $0.20 per share. It also lowered its full-year growth forecast. However, Nordstrom maintains a niche role in the retail space with affluent customers and has a bevy of in-demand brand-name merchandise in its stores.
Not surprisingly, Nordstrom topped the Street's expectations in the second quarter, putting the prior quarter's earnings-report skeptics back in their places. Nordstrom's bad quarter was just a minor hiccup that happens now and again with even the best retailers, and wasn't a thesis-altering event.
Conversely (and switching sectors), biotech royalty company PDL BioPharma's (NASDAQ:PDLI) second-quarter earnings report was what nightmares are made of. PDL BioPharma's business is all about acquiring biotech assets and collecting a percentage of the net sales of drugs utilizing those assets. PDL's main revenue generator was its Queen patent portfolio. However, the majority of these patents expired in Dec. 2014.
With warehoused product having now been sold off, PDL's revenue is shaping up to fall by around 70% year over year, and the company completely shelved what had been a double-digit yielding dividend. PDL's Q2 report wasn't bad -- it was game-changing terrible, and it should give investors every reason to sell at this point.
Reasons to remain calm, even after terrible earnings
Matt Frankel: As Sean said, if a company's earnings report reveals a fundamental change in the business, it may be time to reevaluate. However, companies often produce disappointing earnings because of temporary factors and things beyond their control.
For example, many banks have been producing dismal profits for some time now, mainly because of the record-low interest rates that don't seem to want to go away. As one example, Bank of America (NYSE:BAC) generated $0.36 per share in earnings during the second quarter, which translated to a 6.48% return on equity and 0.78% return on assets -- well below the 10% and 1% industry benchmarks.
However, investors should take these numbers with a grain of salt. Bank of America has said that an increase of just one percentage point in interest rates would translate to $8 billion in additional profits. If the bank's earnings continue to disappoint for the time being, investors should definitely not panic -- interest rates will go up, it's just a matter of when. (In fact, you'll notice in the disclosure at the end of this article that all three authors personally own Bank of America shares.)
There are a few other reasons for earnings disappointments that shouldn't necessarily scare investors away. Currency headwinds are another one, as are one-time expenses such as legal charges and restructuring costs. The point is that there are literally hundreds of factors that contribute to a company's profitability (or lack thereof), and many of them aren't thesis-changing for long-term investors.
Build a panic-free portfolio by knowing what you own
Jason Hall: My colleagues discuss some very solid reasons why a company's earnings report should have you paying very close attention, and potentially even taking action with its stock. But I just can't get behind the idea of panicking over the results of a single quarterly report, pretty much ever. Frankly, if you're ever in that situation, then you may want to reevaluate how you invest, because you should never be in a situation where you've got so much capital exposed that a single bad earnings report causes you to panic.
It starts with understanding as much about a company as you can before you invest in it. Sean's contribution above is a prime example of this. If a company's business is heavily predicated on patents that are set to expire, a potentially disruptive but so-far unproven technology, or some other situation where its business results are set to swing wildly, then it's far more likely to report "panic-potential" earnings results that fall short of expectations on occasion. But by knowing this is possible (or even likely) before you invest, you'll be far more likely to invest an amount where you can comfortably stomach the risk.
Maybe as importantly, you'll have a better handle of what those results really mean for the company's long-term prospects. After all, sometimes a market panic is actually a great opportunity to buy. If you want to be able to tell the difference -- and to profit from it -- you have to arm yourself with knowledge of the companies you invest in.
Jason Hall owns shares of Bank of America. Matthew Frankel owns shares of Bank of America. Sean Williams owns shares of Bank of America. The Motley Fool recommends Bank of America and Nordstrom. 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.