How to Gauge the Quality of Earnings Beats

Like many of you, the baking pace picks up speed in my house the third week of November. I prepare traditional pies for returning family members and coffee cakes and muffins for the onslaught of house guests.

I was in the middle of my baking frenzy when I noticed my butter supply being a bit short. Instead of the usual generous slab used to grease pans, I began to frugally apply a thin layer as part of my conservation effort, a tactic to avoid a grocery store run on a busy weekend.

Like most people, when something, anything, is abundant, we’re pretty cavalier about our use of that item. Whether it’s spending a bit extra on a dinner out when the bonus check arrives or letting the tap run too long when the water heater is going strong, humans aren’t terrific at consistent behavior in times of feast or famine.

Which brings us to Wall Street. The recent weakness in the stock market is changing investor behavior. A famine in stock gains is forcing a more critical view of earnings. When investors feasted on abundant stock gains, they gave companies a wide berth when reporting earnings. As long as revenue and earnings per share met expectations and guidance fell within an acceptable range, the stock moved up.

Now that a post-earnings bump is not a guaranteed event, investors are putting on their thinking caps when reviewing numbers.

The Decision Tree

The decision tree regarding whether a stock rises or not is now a lot more complicated.

The old decision tree ran something like this:

Did the company beat earnings per share?
YES: stock moves up
NO: If guidance is good, stock moves up. If guidance is weak, the stock might falter a bit. Only under draconian circumstances would a stock fall more than 15%.

The new decision tree has many more branches and follows this logic:

Did the company beat earnings per share?
YES, but…

How was the quality of the beat?

Teasing out the details of a high or low-quality earnings beat can be complicated. However, a simple rule of thumb is whether the better-than-expected results were above or below the operating income line of the income statement.

Numbers above the line include revenue, cost of goods, product margins, and operating expenses. Higher than expected revenue, better margins, and/or lower expenses will produce a high-quality earnings beat.

Numbers below the line include the number of shares outstanding, the tax rate, interest expense, and the litany of “one-time” charges or income that fall below the operating income line.

Did the company beat earnings due to a lower than expected share count, a lower tax rate or special one-time events? Any of these benefits might be considered low-quality during a bear market.

It wasn’t all that long ago that investors cheered wildly for the corporate tax cut. This dramatic drop in the tax rate magically improved net earnings for most public companies. However, another drop of similar size will not be repeated, making 2019 comparisons all the more difficult.

Below the line boosts are not untoward or adverse but are not typically repeatable events. It is unlikely a company can continue lowering its share count or tax rate indefinitely. However, above the line metrics like sales growth, profit margins, and expense control all provide companies with a roadmap for higher earnings in the future.

As we approach 2019, investors are beginning to realize companies will have to deliver terrific improvements to operating earnings to jump start growth rates. In these murky times, investors are wise to look for trading techniques that provide reliable results. My colleague Jim Fink’s Velocity Trader service does just that.

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