Earnings Experiment Update

It’s always tough getting back into the swing of things on Mondays, especially after spending a leisurely weekend sampling wine in one of our local wine-making regions. (It was fun but it was also a toasty 114 degrees.) Being in a summer slacker mood, I thought I’d take the easy route and check out what I’ve done before. Lo and behold I stumbled across the earnings experiment I began in February 28th’s blog where it was hiding at the bottom of the blog portfolio heap. I’m glad I resurrected it because the results are quite interesting.

The Premise
The premise was to see what happens if one buys stocks whose charts gapped up on good earnings news, and short stocks whose charts have gapped down because of bad earnings reports. So, what I did was to construct two portfolios consisting of five stocks each. The Good News portfolio consisted of equal dollar amounts ($5k/stock) of the following five stocks that reported great earnings on 2/28: Hurco (HURC), VisionChina (VISN), Chart Industries (GTLS), Ctrip (CTRP) and Fluor (FLR). The Bad New portfolio consisted of equal dollar amounts ($5k/stock) of the following five stocks that fell on negative earnings news: RH Donnelly (RHD), Abitibibowater (ABH), Dollar Thrifty Automotive (DTG), Sprint/Nextel (S), and Cowen Group (COWN). End of day prices were used as the cost basis along with $9.95/trade commissions. (No margin calculations are included, however.) The following two tables show the profit/loss profile per trade as well as the overall gain/loss.

A Real Earnings Surprise
Honestly, I didn’t know what to expect, but I certainly didn’t expect either one to do as well as it did. The Good News portfolio is up about 16% and the Bad News one is faring even better with a near 24% gain. Those gains translate into annualized returns of about 53% and 78% respectively. Not bad! The combined return is about 20% or 66% annually.

How long to hold?
The other question I posed in the original blog was how long should I hold the stocks? The answer to that question goes back to setting stop losses. As we’ve been discussing in several recent blogs, how you set your stops is a determining factor in overall portfolio performance. Looking at the Good News stocks, I certainly would have dumped both Ctrip and Hurco when they gapped down on missed earnings on May 15th and May 23rd respectively. Doing that would have improved the bottom line by a few percent.

On the Bad News side, I know I would have been tempted to cover Abiti when it broke $10 resistance on March 24th for only a 6% gain. I also would have gotten out of Sprint on May 5th when it broke above $8 resistance for an 8% loss. Doing this would have lowered my total yield to around 16% which still isn’t too shabby. (I would have probably been tempted to exit Cowen on May 16th for a wash.)

Additional Pointers
It looks like this approach to buying the good news and selling the bad can be quite profitable. One thing I would suggest is that if you have a choice among portfolio candidates, go with those in rising sectors for the good news guys, and in sinking sectors for the bad news bears. For example, an oil exploration stock with bad earnings will probably not be as good a candidate as a subprime lender for the Bad News portfolio.

To sum up this approach, scan earnings news for potential candidates , look at their charts to see if they gap either up or down, then research them and their sectors. Once you have your portfolios, monitor them daily to see if they’re breaking any major support or resistance levels, and note their next earnings release dates. Remember that even good stocks with good earnings can drop in value on the day of an earnings announcement. If they do miss earnings and their stock gaps down, that is a definite sign to get rid of them.

A Birthday Note: From Dr. Kris and her cast of imaginary characters, Dimitri and Fifi, here at the Stock Market Cook Book, we all want to wish Professor Pat, our esteemed colleague and frequent contributor, a very happy birthday!

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