An Earnings Experiment

Since the market is in the midst of earnings season, I thought today it might be fun to perform a little experiment. The premise goes like this: What if I buy the stocks that reported the best earnings and shorted those with the worst? Would I make money and how long do I need to hold these stocks?

These are both good questions since many traders and investors out there do play stocks according to their earnings. I've never done it and so I am just as curious as you are to see if this approach is profitable. This scheme has nothing to do with my recipe, Earnings Etouffe, since that strategy involves playing stocks before they release earnings. This is a strategy for after earnings are reported.

Looking at todays earnings news, I came up with a list of both winners and losers and culled the five top ones in each category that I felt (based on their charts) looked like they might have the most potential for profit. Before I list them, I want to give you a brief primer on what constitutes “good” earnings news versus “bad” news.

Good News:
1. The company reports record profits.
2. The company reports increased sales orders.
3. The company blows away earnings estimates (made by industry analysts).
4. The company increases future guidance, meaning they expect to be more profitable than they previously thought.
5. Analysts upgrade the stock and/or raise their price targets.

The Bad News is exactly the reverse. Usually, the more of the above criteria contained in an earnings release, the bigger the move in the stock price.

Here's my list of stocks that jumped today on good earnings along with a brief explanation of why they moved:

Hurco (HURC): Up 32%. First quarter per share earnings jumped 45% over last year. New orders increased 30%, and they blew out analyst estimates.
VisionChina (VISN): Up 16%. Total year-over-year revenues grew 659%. Net quarterly income grew 53% . (There was only one brief press release on this.)
Chart Inds. (GTLS): Up 20%. Quarterly earnings jumped 91%, quarterly sales grew 26%, they clobbered analyst estimates, and raised 2008 guidance.
Ctrip (CTRP): Up 15%. Fourth quarter profit and revenues more than doubled, beating analyst estimates. One analyst raised price target from $75 to $78. (This is a Chinese stock that trades as an ADR here.)
Fluor (FLR): Up 10%. Fourth quarter profit more than tripled on increased sales and a one-time tax benefit. They also raised 2008 guidance.

Here's my picks of the losing stocks that reported bad earnings news today:

RH Donnelley (RHD): Down 44%. Even though the company narrowed its fourth quarter loss, it lowered 2008 guidance and stopped paying its dividend. A key company executive also stepped down.
Abitibibowater (ABH): Down 10%. This company is a recent merger (which is why the company name is a mouthful) and it's a little tricky to give exact numbers. In essence, company sales are down due to the decreased demand for its products (newsprint).
Dollar Thrifty Automotive (DTG): Down 9%. Reported widening losses and didn't meet analyst's earnings expectations.
Sprint/Nextel (S): Down 10%. Reported a massive fourth quarter loss, predicted continued customer weakness, and stopped paying dividends. Fitch also lowered the company's investment rating and put it on its negative watch list. Ouch! (I had Sprint once. They're coverage was awful and customer service nonexistent. I'm very glad to short this turkey.)
Cowen Group(COWN): Down 13%. Fourth quarter revenues swing to a loss missing analysts estimates.

What I'm going to do is set up dummy portfolios for each of these; that is, I will go long the above stocks that reported good earnings news and go short the five that reported negative earnings news. Each stock will be equally weighted according to price which I'm setting at $5000/stock. My entry point will be today's closing price, and I'm using $9.95 as my commission cost.

During the next week or so, I'll be revisiting each portfolio to see how we're doing. Not only do I hope this will be educational for both you and me, but fun as well.

As for last night's dinner, Ms. Bartiromo does indeed look as lovely in person as she does on TV, and she's as delightful as well. I was hoping for some light Italian fare, but unfortunately it was chicken. Ah well...at least the company was stimulating.