Below is a weekly update from our Chief Investment Officer, Dr. Scott Lummer. He co-hosts an audio segment entitled “Market Matters.” In this week's show, Scott discusses earnings season. He explains why earnings announcements are important, and why the stock market’s reaction to those announcements is complicated. He also describes the risk of individual investors trying to predict company earnings. Each week he covers a different piece of investment news focusing on recent events in the capital markets, and relates them to Savant Investment Group’s perspective on investing.
Daphne: Welcome to Market Matters, a weekly discussion about investing in today’s capital markets. I’m Daphne Feng and, as always, I’m joined by the Chief Investment Officer of Savant Investment Group, Dr. Scott Lummer. Scott, I read reports in the news that we’re in the middle of earnings season. What is earnings season?
Scott: It’s about a six week period starting about two weeks after the end of the quarter during which most companies announce their earnings for the previous quarter.
Daphne: Why is there a specific season?
Part of the reason is it take anywhere from two to eight weeks after the end of a quarter for the accounting departments of the various companies to prepare the financial statements. But also, companies get into a habit of announcing their earnings on a particular day, such as the fifth Wednesday of the quarter. Analysts who follow that company develop expectations of getting that information on that day. So even if the accountants can process the information more quickly, the company often waits until their traditional day of announcing.
Daphne: Why are these earnings announcements so important?
Scott: In theory, the reason an investor buys the stock of a company is for a piece of the earnings. If a company generates high earnings, it will be able to pay higher dividends, and its shareholders will generate cash flows.
Daphne: But many companies either pay no dividends, or very low dividends, reinvesting most of their earnings.
Scott: You’re right, but the higher the earnings for those companies, the more they will be able to reinvest, meaning their growth rates will be higher. Eventually, when they do pay out dividends, those dividends will be higher. Again, the stock price will be more valuable.
Daphne: So last month Amazon reported that earnings went down. Does that mean it’s stock fell in value.
Scott: Yes it did – the stock actually fell by 10% the day after the company announced it lost money.
Daphne: Last month J.P. Morgan announced its earnings declined, but its stock price went up. Why does that occur?
Scott: It’s all about expectations. The analysts that are closely following a stock develop expectations about the earnings for a company, based on past earnings, overall economic and industry forecasts, and other company information, such as the success of recent product launches. So even though J.P. Morgan’s earnings fell slightly, the profits were much higher than the average analyst’s forecasts, so the stock price went up
Daphne: O.K., but last week Visa announced that earnings increased to $2.17 per share, which was higher than the consensus estimate of $2.09 per share, and the stock price still went down. Why did that happen?
Scott: Two reasons. First, the overall market went down, because of general poor economic news. Second, in the announcement about earnings, Visa also announced that it’s revenue for the rest of 2014 would be lower than expected. That news was more important than the single quarter’s earnings for Visa.
Daphne: Seems like the stock price reaction to earnings news is complicated.
Scott: It is – that’s the risk of buying individual stocks, particularly for the short-term. As an investor, you could have done a lot of research to predict Visa’s earnings, purchased the stock the day before they announced their earnings, been exactly right in forecasting that earnings would be higher, and still lost 4% because of other news.
Daphne: Most of Savant’s clients invest in mutual funds. So, should individual investors care about these announcements?
Scott: In the aggregate, yes. Overall, if the earnings news for companies during a quarter is good, overall market indexes are likely to increase in value.
Daphne: And that’s Market Matters. Thank you Scott and thanks to all of you for listening. Please join us next week when Scott and I will talk about the impact of inflation.