Earnings are about to look much worse. Here’s how you can take advantage! [Wednesday: The Independent Investor]
Miles Everson’s The Business Builder Daily speaks to the heart of what great marketers, business leaders, and other professionals need to succeed in advertising, communications, managing their investments, career strategy, and more.
A Note from Miles Everson:
We’re thrilled to share with you another investing insight in today’s “The Independent Investor.”
Every Wednesday, we publish articles about investing because we believe we can achieve true financial freedom through wealth creation.
In this article, we’ll talk about why earnings are about to look much worse for the next few quarters and why you shouldn’t panic.
Do you want to know why?
Continue reading below to know more.
The Independent Investor
Nowadays, there’s a lot of uncertainty that’s surrounding the U.S. market because of a looming recession. As a response, companies, especially public ones, are bracing themselves for an economic downturn.
Since tough times are just around the corner, the management teams of firms that will be affected have to come up with ways to survive.
Most of these companies will probably attempt to cut costs to protect their margins and this may come in the form of reduced expenditures, restructuring, and layoffs. However, there’s another way for these businesses to survive during tough times and improve their long-term outlook.
The management teams of companies do their best to give investors better outcomes than expected. After all, stock prices rise based on good results.
Based on the statement above, it’s reasonable to assume that management would do everything to bring good results… but there’s actually a time when company leaders seek to miss expectations instead of beating them.
When a firm expects negative outcomes, a savvy management team would try to get all that bad news over with in the hopes of making future quarters look better by comparison.
This tactic is called the “big bath.”
Management teams have a lot more control when it comes to reporting profits. If they think earnings will fall slightly, they can choose to be more pessimistic about the company’s outlook and write down the value of its assets, thereby taking a huge loss.
By making poor results look worse through the “big bath,” the management team of a firm can make a company’s profits look a lot better in future quarters, thereby beating investor expectations.
According to Professor Joel Litman, Chairman and CEO of Valens Research and Chief Investment Officer of Altimetry Financial Research, lots of companies in 2009 underwent a “big bath,” and this led to earnings for the S&P 500 as a whole to take a massive nosedive
Professor Litman said that the event sent his clients into a panic… but not him and his team.
While his clients were asking what stocks to hold or short, Professor Litman searched for compelling opportunities. Throughout this process, he and his team noticed that lots of companies had terrible earnings and looked bad on paper. However, they didn’t stop there.
After cutting through all of the accounting noise, Professor Litman realized that most of the firms his team looked at were just taking a “big bath.”
So, what happened next?
Professor Litman advised his clients to buy the stocks of companies that were going to see better days in the long run. Since these firms’ stock prices had tanked due to the strategy, it was easier for buyers to acquire a piece of these businesses.
In just a few years, Professor Litman’s clients made gains that went over 300%!
As interest rate hikes continue to work their way through the economy and as long as uncertainty looms in the market, companies will use the pessimistic outlook to their advantage and one of the ways they can do that is by using the strategy we discussed above.
In fact, Professor Litman expects that we will see a new wave of “big baths” in the coming quarter.
So, what should you do?
Keep an eye out for companies that severely miss their earnings expectations as this is a surefire way of knowing that they’re taking a “big bath.” Since the stock prices of the firms that use this strategy will take a nosedive, that’s the sign for you to buy cheap and reap the benefits later on down the line.
(This article is from The Business Builder Daily, a newsletter by The I Institute in collaboration with MBO Partners.)
About The Dynamic Marketing Communiqué’s
“Wednesdays: The Independent Investor”
To best understand a firm, it makes sense to know its underlying earning power.
In two of the greatest books ever written on investing, the “Intelligent Investor” by Benjamin Graham and “Security Analysis” by David Dodd and Benjamin Graham (yes, Graham authored both of these books), the term “earning power” is mentioned hundreds of times.
Despite that, it’s surprising how earning power is mentioned seldomly in literature on business strategy. If the goal of a business is wealth creation, then the performance metrics must include the earning power concept.
Every Wednesday, we’ll publish investing tips and insights in accordance with the practices of some of the world’s greatest investors.
We make certain that these articles help you identify and separate the best companies from the worst, and develop your investing prowess in the long run.
To help you get on that path towards the greatest value creation in investing.
Hope you’ve found this week’s insights interesting and helpful.
Stay tuned for next Wednesday’s “The Independent Investor!”
Head of Marketing
Valens Dynamic Marketing Capabilities
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