Wednesday, March 25, 2009

The impact of blow-out earnings in an unfriendly market

Dr. Kris isn't too big to admit that sometimes she can just be plum...uh...incorrect. Yeah, that's the word. One thing that I wasn't quite correct on was my analysis of post-earnings plays as given in Recipe #12: Post-Earnings Pot Roast. I claimed that the recipe of buying stocks on companies that blew-out analyst earnings estimates to the upside could be purchased and held right up until the next earnings release (barring any intermediate negative news on the company), and vice versa with negative blow-outs. (In this latter case, you would take a short position until otherwise indicated.)

This is a valid recipe but I failed to mention one major ingredient—market direction. If the market is trending upwards, then taking long positions on companies that beat analyst estimates and holding onto them up until their next earnings release generally provides positive returns. What I failed to look at was what happens when the market is trending in the opposite direction--does that have any impact on the strategy?

Yes, it does. Take a look at the price movement of Myriad Genetics (MYGN) shown below. You can see two humps (for lack of a better word) appearing in its daily chart since November. I knew when I saw them that they were most likely the result of blow-out earnings and I was right. On 2/3/09, the company reported 43 cents/share as opposed to analyst estimates of 32 cents, and on 11/4/08 they reported 30 cents/share as opposed to an estimated 14 cents. But if you had played the earnings after each announcement expecting a big pay-day, you might have been disappointed.

The chart shows that investor euphoria only lasted about a week to a week and a half before the stock retraced back to its trend line. Don't get me wrong--had you held the stock since last November, you'd be sitting pretty, but that has more to do with the company's products and fundamentals rather than momentum.

Compare this chart with that of the S&P 500 and you can see a rough correlation between the stock's price and the trend of the overall market. Yes, Myriad has moved up while the market has moved down, but you can see how relative movements in the broader market influenced the movement in the price of Myriad. I think that if the broader market had been trending up instead of down, Myriad would be trading at a much higher price than it is now and the trend line in the chart might then be situated at the high points of the humps instead of well below them.

Conclusion and apology
To those of you who might have been following my post-earnings strategy, I truly apologize for the lack of foresight in including market direction as a fundamental ingredient. Cooking without it can make for some unpalatable long-term returns. If you do wish to play this strategy against the market grain, I strongly recommend taking a quick profit as your gains could evaporate faster than an AIG executive's bonus.

Note: I'll be modifying Recipe #12 to reflect this discussion.

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