Session 25 (of 42): Information Trading - Earnings Reports

0:00 Hi, welcome back. In the last session we talked about how equity research analysts, sell-side analysts, spend significant amounts of their time trying to forecast what the a company's earnings will be in the next quarterly release. In this session I want to focus more specifically on that day when earnings are released and how the market reacts to earnings reports. After all, this is the most common way in which companies reveal information to public investors is reports. Four times a year in the US and much of the and increasingly in much of the world.

0:37 So let's talk about those announcements and why it is so difficult to gauge whether it's good news or bad news. As I as I mentioned earlier, this is your primary device as a company to let the world know what your operations are doing, how much your revenues are, what your margins look like, what your earnings are. And that information tells you not just what the business is doing, what the company's business is doing, but it does give you information about the sector, sometimes about the competition.

1:04 Not surprisingly, when earnings report comes out there's a price effect. Now at first sight you're saying at at first your first reaction would be that's obvious. If earnings go up the stock price should go up, if the earnings go down stock price should go down. Not necessarily and here's why. When an earnings report come out comes out, markets don't react to the report per se, but what the report contains is news relative to what they expected to say.

1:29 Put simply, a high growth company that reports a 30% growth in earnings might have a negative surprise because people are expecting a 40% growth. A declining company that reports a 5% drop in earnings might see its stock prices go up because people are expecting a 10% drop. This is an expectations game and actual numbers are compared to expectations. We'll talk about what goes in those expectations. Sell-side analysts used to be the drivers of those expectations, but increasingly the market seems to have a created a mind of its own.

2:02 So, you got the earnings report day, and you look at actual numbers come out to compare it to expectations. Now, when you look at the earnings reports themselves, usually companies report earnings on pretty much the same day every year. So, if your first quarter earnings come out in April 16th, you should expect to see the earnings report next year. We'll talk about what happens when companies delay reports relative to expected date. They reveal information to their about their current and future product, and increasingly, as we will see, they supplement that information about what happened in the last quarter with guidance about what they see coming up in the future. And as I mentioned, in an efficient market, there should be an instantaneous reaction to the earnings report. If it contains better than expected news, your price should pop up.

2:51 Worse than expected news should drop down, but roughly the amount it should, and then you should see no drift afterwards. So, we know what we should expect to see. Let's see what the actual earnings report reactions look like in the market. In this graph, you know, what what the researchers did is they broke down earnings reports based on the surprise, where actual earnings were compared to expected earnings from most positive to most negative. So, the blue are the the companies that report the most positive earnings surprises, earnings being greater than expected. The red at the bottom is the most negative.

3:31 And this in this study, they looked at what the stock prices were in the days around the earnings announcement, starting third, you know, 60 days before, going 60 days after. Now, first thing you will notice is day zero is the earnings report. You see that prices tend to start drifting in the days before. And they drift in the right direction. The most positive reports you start to see stock prices increase fairly substantially in the 6, 7, 8 days before the report.

4:03 Now, you could you could be one of those great market efficiency believers who says show this shows you how markets can forecast what's coming. Or you could be a cynic and say this suggests there's some leakage of information. Which is a nice way of saying somebody's trading on this public information before it goes public. We'll hold our noses and hold on because clearly there is a drift up or down depending on what's included in the report.

4:29 The earnings report comes out. There is an additional effect which is consistent. So we have a very positive earnings report. In addition to the drift up in the days before, on the day or the moment of the announcement you see the stock price go up. But then if you track it in the days after, it continues to drift upwards. And that's interesting because that is not consistent with an efficient market. The most negative reports, there's a drift down before the report, there's a drop on the day of the report, and then there's a drift down in the days after.

4:59 In fact, if you focus just on that post-announcement drift, first thing to recognize, we're not talking about 100% or 80%. It's a fairly modest drift, but it is a drift. In the in the 60 days after the most positive reports, the stock price goes up about 5% more than expected. After the most negative reports, it goes down about 2% more than expected. So -2%. So there's a post-announcement drift. And that is something we're going to talk about as investors is there a way to take advantage of it.

5:34 So earnings reports affect stock prices consistently. Good news in the form of positive surprises. Now, the question is how are expectations formed? The way in which these studies were constructed is they use analyst expectations as the base, they compare the actual number. And until about 10, maybe even 20 years ago, that used to be legitimate. Analyst expectations became the expected number. But one of the things that started happening is companies started gaming the system and beating analyst expectations more frequently than they should. Because remember, if these expectations are unbiased, half the time you should beat expectations, half the time you should not. There's some sectors like technology where companies were beating expectations 80% of the time. The market learns. In what way? If you consistently beat expectations by 5%, you know what the market's going to do, right? If your earnings come in 3% higher than expected, that's going to be viewed as a negative surprise. Something to think about as you look at these studies is how that expectations game has changed.

6:38 Earlier I talked about how earnings reports tend to come out on a particular day every year. This There's one study that looked at what happens to earnings reports that come out earlier than expected, which are relatively few, and later than expected, which happens fairly frequently. So, company's earnings date is April 17th, April 17th comes and goes, and there is no earnings report. April 18th comes and goes, no earnings report. It's delayed by a day, delayed by 2 days. Now, stop and think about it. As investors, when you see an earnings report delayed, what's your first reaction?

7:13 There must be some bad news, right? Nobody with good news is going to delay the report. And you can see already how markets have to behave accordingly. And the longer you delay a report, the more your price drifts down because people are building in the expectation, that probably rightly, that you're more likely to be conveying bad news. And finally, if you focus on the day of the announcement itself, and this is a study that looked at how quickly prices adjust, and looked at the immediate impact, and then tracked the stock one month one hour after, two hours after, three hours after. This is across all stocks.

7:49 Across all stocks, about 91% of the price reaction has happened within three hours of the report. What does that mean? If you're going to be trading on earnings reports, you better be trading in time because you wait three hours after the report, much of it is faded. And if you look at the most liquid stocks, this adjustment is even faster. It's in In fact, one of the interesting things again that has happened in markets is because these reports often come out after close of trading.

8:16 And there is, you know, you can actually see the pre-market price of the company. The adjustment actually happens in the pre-market. And by the time the stock opens the next day, almost all of the adjustment has happened in the most liquid stocks. So, when you look at these earnings reports and how they affect prices, there are some things that seem to come out. First is the quality of earnings seems to matter. Company comes out and says, you know, its earnings were 10% higher than expected. That's good news, right?

8:45 But it also has to reveal its entire entire quarterly reports, and you start digging through and you discover that the 10% jump came almost entirely from sales made by the company in the last two weeks of the quarter for which they haven't been paid yet. It shows up in your statement of cash flows as receivables jumping. Well, that's not a great price in a earning speed. You might decide that that's a lower quality positive surprise than one where the company sold more than expected and made more than expected. So, the quality of earnings matters, which also means that your accounting has to get much more solid.

9:21 You agree? You have to play the role of a forensic accountant and not just react to the top line or the bottom line number. Second, and this is I think one way to measure earnings quality is look at accrual earnings, which is what companies report as earnings per share. But then if you look at the full state financial statement, you look at the statement of cash flows, you can look at cash earnings. Companies where accrual earnings jump a lot, but cash earnings don't, you have to be a little more skeptical than companies where both increase. So, earnings quality matters, and there are forensic accounting metrics you can use to gauge the quality of earnings.

9:58 As I mentioned earlier, companies increasingly have come under pressure. And many have done this voluntarily when they report their earnings to also give you give investors guidance about what they see coming down the pipe in the next year, the next 2 years in terms of revenues and margins. So, a company might say, "We beat earnings by 5% last quarter, but you know what? Things don't look great for the next year or the next quarter, and we want to let you know."

10:23 We'll talk about why companies might convey negative guidance or guidance that doesn't look as upbeat as people thought it was going to be. But when that guidance comes out, just as with the actual earnings, investors are comparing the guidance to expectations. There have been times in the last few years where companies beaten earnings with its actual earnings, they have beaten expectations, but provided guidance that's so negative the stock price drops. And that guidance process troubles me a little bit because it's open to gaming.

10:56 And here's what the gaming looks like. Companies know that their earnings are measured against expectations. One way they can manage expectations is by providing guidance that's more negative. So, sometimes the negative guidance is not so much because a company thinks the future doesn't look as good, but because they want to bring down expectations for the next quarter so they can beat those expectations. You can already see that earnings report day is gaming personified in every dimension because it's about managing and beating expectations.

11:29 But if as an investor you decide that you are going to build an investment philosophy around earnings announcements. There are a couple of ways you can do it, right? One is you can play the drift. Take the companies with the most positive earnings surprises with the biggest jump on that that the day the earnings come out and hold them hoping and praying that the drift still continues that company. My guy my suggestion there is it's more likely that you will see a drift in the less followed smaller companies. So if you're going to play this game, maybe on those companies.

12:01 You know, smaller less liquid companies because that's where the drift is going to be greatest. But the bigger money is actually getting ahead of the game. One way you can get ahead of the game is have access to inside information about what's in the earnings report, but that is potentially illegal in much of the world. Or you can do your own research and perhaps you can come up with a better way of forecasting what the earnings are going to be than equity research analysts are. And today we have the data and the tools to be able to do this.

12:30 And maybe that'll become your competitive advantage. It's a quarterly earnings game and you're a little better at it than the typical equity research analyst and you use it to full effect to capture that jump on in the price around the most extreme announcements. I hope you found the session useful. And I thank you very much for listening.