A long-term investor's guide to earnings reports

Quarterly reports can help you track a firm against your long-term expectations, but one earnings miss is not always--or even often--cause for concern.

Karen Wallace 14 October, 2015 | 5:00PM
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Question: How much attention should I pay to quarterly earnings reports? Should I just tune them out?

Answer: While it's true that it's probably a good idea not to put too much weight on how a stock you own performs relative to analysts' consensus estimates over one or two quarters, it's probably not a good idea to completely tune out quarterly earnings reports, either. After all, earnings reports inform your longer-term views.

One oft-repeated, though helpful, tip is to write down your thesis for owning each investment on a piece of paper and refer back to it periodically. (Though this sounds ridiculously simplistic, I've heard this advice repeated by countless investors and even professional money managers.) We're human beings first and investors second; we can get spooked by bad news and want to jump ship, even when our original thesis still holds true. Alternatively, we can become attached to investments that are no longer tracking with our long-term expectations, perhaps because we're interpreting new data through a lens clouded by confirmation bias. Having a record of why you originally bought a stock and what your long-term expectations for it are can help you objectively evaluate earnings reports with a long-term view.

The short- and the long-term view

When it comes to earnings, it's as though there are two types of players at the same table. One player is focused on the short term and whether or not a stock will beat earnings, and it's usually this type of player who is responsible for a stock's movement up and down immediately following an earnings release. There is usually a lot of trading activity surrounding earnings surprises--a company's stock price can shoot up when it beats earnings forecasts, and it can drop sharply when it doesn't.

The other player is focused on the long term, and what a single quarterly result means in the context of a multiyear trend. And it's easier to predict what's going to happen over the long term than what will happen in the next quarter or two. In a general sense, as an investor, you would expect quarterly earnings to follow a certain trend line over the long term, and you can be satisfied if the company you own is staying within that trajectory. It makes sense to have an expected range within that trend, making sure it's wide enough to account for the volatility one would reasonably expect in that sector or industry.

That said, it's also possible for a company to show you a quarterly result or two that leads you to reconsider your original thesis. Let's look at two examples, below.

When a miss is not cause for alarm

Quarterly earnings reports can be a window into how well a company is tracking with your long-term expectations, but investors should be aware that they are not always going to be in a straight line. Real life is lumpy. You may even need to readjust your long-term expectations as a result of some near-term news. But in the absence of thesis-shattering developments, an earnings miss is not necessarily an indication that it's time to jump ship.

For instance, even when a company misses consensus estimates by a considerable margin, you can look beyond the headlines to find clues as to how well a business is managed. In this way, an earnings miss can give you insights into how well a management team executes when it comes to things they can control, as well as how well it responds to things that are outside of its control, such as currency movements.

For instance, after  Yum Brands (YUM) reported on Oct. 7 that its third-quarter China-division sales comps had fallen significantly short of consensus expectations, the stock plunged more than 18%.

As Morningstar strategist R.J. Hottovy points out in a recent analyst report, roughly 40% of Yum's operating income comes from China, so the stock is tied to market perceptions of macro and consumer trends in the region. Hottovy believes these pressures are largely macroeconomic in nature, as other consumer-facing companies in the region have also noted a sentiment-driven reduction in spending following August's equity-market volatility and yuan devaluation.

While the China comp is disappointing and did result in Hottovy lowering the company's fair value estimate by 8%, he notes that he believes the company's wide economic moat remains intact, and the China comps overshadowed several positives in the quarter, such as some savvy moves management has made. In order to accelerate same-store sales growth, improve operating leverage, and drive returns on invested capital across brands, Yum's management has put greater emphasis on product-customization capabilities, improved restaurant utilization and daypart expansion, increased use of digital ordering and marketing efforts, and worked to make brands more relevant to a younger/millennial audience.

When to re-evaluate your thesis 

One earnings report is usually not sufficient to throw in the towel on a company in which you have high conviction. However, it's possible that a bad earnings report is an early warning sign that exposes cracks in your investment thesis. Again, it pays to look at it through the lens of what you expect over the longer run, and whether you're right about a company's competitive position and growth prospects in the industry in which it operates. 

In cases where new evidence reveals that your thesis for a stock is no longer on track, it can make sense to sell it. However, that is often easier said than done. In fact, recognizing when you're wrong and when it's time to move on can be one of the hardest things for investors to do. We need to be careful about what psychologists call "loss aversion," where investors often don't want to recognize a loss or admit that they're wrong. It could be very damaging to your wealth to stick with a company that's not quite what you thought it was just because you don't want to recognize that loss. You could end up with a much worse loss down the road.

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Karen Wallace

Karen Wallace  Karen Wallace, CFP® is Morningstar’s director of investor education.

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