Friday, July 11, 2008

Earnings Etouffe Redux

My very first recipe was Earnings Etouffe. In a nutshell, the strategy is simply to buy stocks that have raised their earnings guidance and sell them just before their next earnings release. In my April 7th blog, I mentioned 15 stocks that had raised estimates that I thought would be good candidates for this recipe. Since second quarter earnings season has just kicked off, I thought I'd go back to these stocks and see how well they would have performed.

Portfolio construction
The First Quarter Earnings Etouffe Portfolios were constructed according to the following parameters:
1. $5000 per position, giving a total portfolio value of $75,000 (15 stocks x $5000)
2. No margin was used; account interest of 2.5% paid quarterly
3. All transactions reflect end of day prices
4. $9.95 commission/trade (no other fees included)
5. Thirteen stocks were purchased on 4/7/08; MANT was purchased on 4/15 due to volatility and FCN was bought on 4/16 when it bounced off of support. (I mentioned both of these issues in the April 7th blog.).
6. Stocks were sold according to two scenarios:
Scenario #1: Stocks were sold just before their earnings were released. (This is according to the Earnings Etouffe recipe.)
Scenario #2: Stocks were held over earnings and sold on or after the date of release, depending on the time. (Companies reporting before the bell were sold at that day's market close; those reporting after the bell were sold at the close of the following day.)

Comparison of the two scenarios So, how did these two portfolios perform? Porfolio #1, the one where stocks were sold just before earnings, gained 3.5% (18% annualized return), while Portfolio #2 in which stocks were held over earnings gained only 2.3% (14% annualized return). What's interesting to note is that the field was evenly divided: 7 stocks fared better after earnings, 7 fared worse, while one essentially remained the same (FTD) . (See table) Although the percentage is even, the results obviously weren't. Two stocks, VVI and ASTE, dropped significantly which contributed to the underperformance of the second scenario. Now fifteen stocks is by no means a representative sampling but it still illustrates my point of selling before earnings.

Comparison with the S&P 500
Compared with each other, Portfolio #1 outperformed #2, but they both outperformed the S&P from April 7 - June 17. During that time, the benchmark index was down 1.6%. From this it seems that the tenets of this recipe are valid even in times of market decline. So if you're interested in playing this strategy, now is a good time to familiarize yourself with Recipe #1 and go stock hunting. Don't forget that you also have the option of using options, thereby increasing returns. There's still plenty of time to get in on this earnings season. Good luck and happy weekending!

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