Peter Hodson: A stock can decline on good earnings news for a whole slew of reasons, and not many of them are bad

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Have you ever had a company report great earnings, or what you thought were great earnings, only to see its share price plunge 20 per cent or more after the earnings release? Sure, you have. We’ve all been there.

These days, it seems like a pretty common event. Investors don’t know whether to go all in on the stock market or go all into cash. The result: heightened volatility around earnings releases, even for good companies reporting great results. The great results may not be “great enough.” Or, they might represent peak earnings.

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It can be painful for long-term holders when this happens. Seeing a stock quickly decline might cause you to re-evaluate your thesis about holding that stock. But it really shouldn’t. Often, a stock can decline on good earnings news for a whole slew of reasons, and not many of them are bad. Here are five of those reasons, but note that we are just talking about companies reporting good results; companies reporting bad results are another story altogether.

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Maybe it’s just the market

In 2022, our i2i hedge fund owned some good companies that consistently beat earnings estimates and often raised earnings guidance as well. But it didn’t help. These stocks often still went down, sometimes a lot, even with such good fundamental news.

Why? Well, if you recall, 2022 was all about inflation and interest rates. Investors were worried that inflation was going to get out of control and higher interest rates were the only solution. Your company just reported 70 per cent growth and upped its guidance? Who cares? Time to sell because of inflation. It was often a painful experience for growth managers.

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There is little one can do in such a market, other than head to cash or change stripes and become a value investor, which is fine if that’s your thing. Patience will help. Great companies will often go down when everything goes down, too. Doing nothing is often the best strategy. After all, your company is still great and the market will eventually calm down, as it did last year and this year.

Focus on the fundamentals

If you’ve been in the stock market for more than a month, you know strange things can happen. The market can be fickle. The market can be irrational. One only needs to look at the sequel to the GameStop Corp. saga that blasted out of nowhere this week, resulting in its shares rising 150 per cent in two days. The market can be frustrating, and unpredictable.

When faced with an unpredictable situation, investors should only focus on what they know for sure — the numbers. If a company reports strong earnings, cash flow, growth and a balance sheet, then you probably don’t need to worry so much if the stock drops 15 per cent on a single earnings release. If business is good, shareholders will eventually figure things out.

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Don’t let the nervous nellies and short-term traders shake you out of a solid stock just because of a little volatility.

Unusual charges to earnings

Hammond Power Solutions Inc., a Guelph, Ont.-based company that makes dry transformers and power products, recently reported solid first-quarter earnings growth. But after rising sharply earlier this year, its stock dropped 27 per cent over three days after the report because it recorded a very large charge due to stock-based compensation expenses.

As the company grows, it hires new employees, and grants options and stock to entice them to sign on. But the stock has soared 172 per cent in the past year. Thus, stock-based expenses (which are non-cash charges) really increased, reflecting the stock’s gains. Investors panicked at the earnings “miss” and sold. But when you think about it, that’s a bit like penalizing the company for having a stock that has done exceptionally well. Seems a bit contradictory to us. Anyway, the stock has recovered a bit from its plunge, up about 11 per cent from its drop.

If one of your companies reports earnings, watch for charges such as the above or other telltale signs that are not bad. Maybe, for example, the company is spending lots of money on research and development, setting up future new products and super-high growth, but hurting reported earnings today. Remember the early days of Amazon.com Inc.? It lost money for decades and could never hit a forecast. That’s because it was spending for the future. We think that worked out OK for the company overall.

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The stock already rose a lot

Many times, a stock will fall on an earnings release even with good results because the stock has already risen a lot in anticipation of those strong results. There will always be investors who sell on the news and there will always be profit-takers after a stock has run hard. Neither should cause long-term investors any concern.

You still need to look at the fundamentals, but often a stock will significantly drop just from profit-taking. It doesn’t mean the story is over. It doesn’t mean the company is in serious trouble. It just means some short-term investors wanted to take a profit.

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Tax, regulatory or index changes

With the new higher capital gains inclusion rates in Canada, we might see more volatility as investors sell prior to the rules taking effect on June 25. A company’s stock might become more volatile as former long-term holders sell in order to save taxes. Does this have anything to do with the company? Nope, but its stock will still be impacted if there are more sellers than there were prior to any changes.

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These declines are perhaps easiest to deal with and ignore. After all, absolutely nothing has changed at the company’s operations. Let the tax sellers have their day, and the stock will likely recover.

Peter Hodson, CFA, is founder and head of Research at 5i Research Inc., an independent investment research network helping do-it-yourself investors reach their investment goals. He is also portfolio manager for the i2i Long/Short U.S. Equity Fund. (5i Research staff do not own Canadian stocks. i2i Long/Short Fund may own non-Canadian stocks mentioned.)


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