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TMFBlacknGold (99.35)

Do Investors Put Too Much Into Earnings?

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August 05, 2010 – Comments (6) | RELATED TICKERS: IQNT , CLWR , HUM

        It is that time of year again. Earnings. Some of us run. Some of us hide. Some of strap in and hang on for the ride. If you're lucky, you have enough investing wisdom to pick some good stocks, but even the best companies have bad quarters. After dismal showings by some of my holdings and some of the stocks that populate my watchlist I started thinking, "Hey, maybe earnings aren't everything.". So why do we like earnings in the first place? They're one of the few pieces of tangible evidence we have to gauge our investments. Just like in sports, potential doesn't add up to much if you can't keep a decent balance sheet (ask JaMarcus Russell).

       But then again, just like everything else in our society an culture, there should be exceptions to missed earnings. Look at ClearWire (CLWR) - a company with exceptionally large spectrum holdings that is in the process of rolling out the nation's largest 4G network - for example. Sure, they missed earnings (if you can call -$0.61 a share earnings). But look at the OTHER numbers they posted. Analysts expected them to add 377,000 customers. They added 722,000! Analysts expected them to cover 2 million people by year's end. They expect 3 million. In just the last few weeks they added retailers such as BestBuy and Cbeyond, expanded to Jacksonville and Grand Rapids, and released the iSpot for Apple users. Potential, due to their spectral band holdings, is the only thing keeping this stock afloat. Their LTE trials might not go so well and manufacturers might be reluctant to sell dual-band phones (phones that use WiMax and LTE), but they can sell their spectra for a few billion. Risk is omipresent, but the gains could be worth it.

     Neutral Tandem (TNDM) is another example. They have, ahem, a slightly better balance sheet than CLWR. Actually, its nearly immaculate. TNDM barely missed an earnings report (yes, they actually earned money ^see above), their 3rd in a row, but that doesn't warrant a 20% drop in one day, which happend after Q1 as well. Their billable minutes increased, but the price per minute dropped. This is true for the entire industry though, so it takes the wind out of the sails of the "their competitors are gaining ground" argument. TNDM has an infastructure in place (CLWR too) - an edge over competitors. TNDM (CLWR too) got out of the starting gates much sooner than their rivals, so its only natural that someone is finally gaining ground as TNDM's growth has slowed. Many Fools would agree that TNDM is a bargain.

     And then there's a company called Humana (HUM). Well I just had to round out my argument - to be fair and balanced. They wrecked earnings and the stock jumped. Expected.

    So Fools, what do YOU think? Is too much weight given to earnings? Do some stocks get a hall pass? Are analysts the ones to blame? I'm looking forward to your thoughts and comments. 'Til then, Fool on!

                    BlacknGold

6 Comments – Post Your Own

#1) On August 06, 2010 at 2:50 AM, Valyooo (99.81) wrote:

I think that one-time earnings shouldn't always make the stock get crushed the way it does.  Sometimes a stock appears to earn a lot or a little do to one time tax or depreciation, which shouldn't effect much.  But what are you paying for when you buy a stock?  You are paying for a return on investment; that return is earnings.  Without earnings the stock is nothing. A stock with p/e of 10, if it had no growth, theoretically is returning 10% of your money per year.

With a stock like BIDU, with a P/E of 90, if they miss earnings, they deserve to get slaughtered.  Why would you pay for something with a P/E of 90?  You are better off with a CD if they are not growing.

Then you have stocks like DJSP with a P/E of under 1...whatever is happening to them is either gonna put them out of business (I highly doubt this) or theyre going to skyrocket. Their earnings revision downward was completely justified unlike the ensuing sell-off.

So sometimes earnings deserve to ruin a stock, sometimes they don't.

But when  you buy a stock you buy it for ROI, not for just value, even if you are a value investor, so earnings must be important.

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#2) On August 06, 2010 at 9:29 AM, TMFBlacknGold (99.35) wrote:

Thanks for your comment ValyooRLholdings. I agree 100%.

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#3) On August 06, 2010 at 12:33 PM, thedogsmad (97.18) wrote:

There is a definite difference in the "earnings" miss by TNDM, a company I have spent much time on.

There is one fact of TNDM's revenue that is important - they make money simply by charging for minutes transited on their network - they will always make more when minutes increase faster than the rate per minute decreases.  This is true for the last 3 quarters - so the question is "Why the earnings drop"

For comparison purposes I give examples of too similar theoretical companies.

 1. The bad example.  This company has higher revenues every Q with either a flat or declining profit.  They increase revenue while margin drops - their reinvestment in the business is nil -- all reinvestiment is to keep the business at a steady state.  Thus costs are increasing as fast or faster to keep the business maintained.

2. The good example.  This company has higer revenues every Q with a flat or declining profit.  They increase revenue while margins drop temporarily due to reinvestment in new business.  If they didn't reinvest they would gain nothing in the future.  Costs in the core business are dropping faster than revenue margins. This company will take a hit to "earnings" while doing this kind of reinvestment.  But it is a much better company to invest in, a logical conclusion.

 

TNDM is the second example -- I have roughly calculated revenue, cost, and respective margins of the core business  -- they have grown in "profitability" by apx 11.5% (margin of error of 2-3%).  The earnings hit comes from the reinvesment from the new business.

 Ironically, if they dropped the new business they would have reported better earnings numbers with no stigma of "increased competition" or viability of the business model.  They chose to do this because of the potential of the new business - a good management decision in my opinion for the long term.

But as always, as viewed though the lens of the stock price, good business strategy isn't always rewarded as a positive by the market until it shows up on paper.   The short term trumps the long when it comes to Mr. Market. It is just a matter of time.

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#4) On August 06, 2010 at 2:29 PM, TMFBlacknGold (99.35) wrote:

Great example thedogsmad! Thanks!

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#5) On August 08, 2010 at 1:01 AM, tekennedy (72.10) wrote:

Earnings fluctuate too easily based off of random occurance or temporary situations to make an individual quarter matter. Earnings in general may often over or understate the true economic benefit the company has achieved over a period(a company who invests heavily in R&D or advertising will reap benefits later hidden in current earnings). Although earnings are often the primary means to view a company balance sheet and cash flow considerations can improve the overall depth of understanding you have of the company you own a piece of.

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#6) On August 08, 2010 at 11:36 PM, peanutgalerygeek (< 20) wrote:

I've always had a theory about the exaggerated price swings that affect stocks, especially on the down side.  

To answer this question, you had to ask yourself first 'who actually controls the price of a stock'?  It wouldn't be you and me. It would be the hedge funds and mutual funds.  That's not because of any conspiracy.  It's just supply, demand, the volume they control.

So, when do they buy and when do they sell?   Those guys can not afford to lose ANY money at all and, therefore, play under different rules than we do.  Once a stock gets any downward momentum at all, they bail en masse, not because of any fundamental problem with the stock.  They get out because, well, the stock is going down and they don't want to lose any money.  This is not stupid.  It is perfectly rational under the rules that they play under.

We don't need to play both those rules.  Personally, I believe that it is only advantage we have over the big boys.   We can watch something go down and, ONLY if we have done our homework, be confident that the down is only temporary and reversed fairly soon.  And if we bet wrong?  It's our money and not anyone else's money.  

I was able to borrow money went AAPL went to 80, pick up some (never enough but I got some) and make a few bucks on the rebound.  The big boys can't do that because that's not their game.  Imagine having to explain a maneuver like that to people who have given you their life savings if it doesn't turn out well.  I made a judgement concerning the risk and went for it.  It was as simple as that.

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