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Saturday, July 24, 2010

What to Expect from Earning Season?

The earnings season has already started and given the dire circumstances of the global economy, investors are taking a hard look at what stocks are reporting.

Earnings tell investors how much the company earned or lost for its owners (shareholders) in the past quarter.

How do you judge earnings in the middle of the worst economy since the Great Depression?

Investors may have different approaches to this problem. Some may factor in the state of the economy and lower expectations accordingly. This is a good strategy, but you must be careful. Some companies may use the bad economy to hide what would have been a poor performance even in good times.

One way to put some perspective to earnings is to compare the company to its peers. For example, if a sector was down 25% for the quarter, it would not be unreasonable to expect leaders of the sector to do better than that, although they may still be down. Companies that matched (approximately) the sector’s performance could be judged as successful for the quarter. Companies that seriously lag their sector’s performance reveal a level weakness that is dangerous in this environment.

Long-term investors will want to consider why a company is lagging behind its sector. The reasons may prove beneficial in the long run, if detrimental in the short run.

For example, a company may be expanding to grab market share from weaker companies. The short-term impact on earnings may pay handsome dividends when the economy begins moving again.

Unfortunately, weak companies may be in that position because of unwise decisions in the past, such as taking on too much debt or betting the economic growth cycle would never end.

So, the short answer during economic turmoil is the same as it always is: Look for strong companies to not fall behind their peers.

These will be the leaders when the economy begins a serious recovery.