How to Profit From Earnings Report Surprises

With the S&P 500 down 17.3% for the last decade, there's no question that stocks are a risky place for the long-term investor. If you had put $10,000 in an S&P index fund 10 years ago, it would now be worth $8,270, whereas if you had kept it in a bank account earning 1% a year, it would be worth $11,046.

If you're satisfied with that 1% return, then there's no need to take risks in the stock market. But if you need to generate more substantial profits and long-term investing isn't the way to make money in the market, what is? Well, you can try to profit by trading on positive and negative earnings surprises.

Here are a few examples of earnings surprises that moved stocks. On Oct. 14, Google (GOOG) reported a 23% rise in revenues and an 18% net income boost while beating Wall Street expectations for non-GAAP earnings per share of $6.67 by $0.97: Its stock soared $60.52, or 11.2%, the next day. The same day, for-profit educator Apollo Group (APOL) announced that its 2011 revenues would fall short of expectations, and it withdrew its 2011 revenue guidance: The stock promptly lost 27% of its value.

Such earnings surprises aren't all that unusual. On Oct. 1, Investing Daily reported that in the second quarter of 2010, 82% of S&P 500 companies reported earnings that beat analysts' estimates by an average of nearly 15%, with average annual earnings growth topping 54%. There was only one earnings decliner among the 10 S&P 500 sectors -- telecommunications services, which "exhibited negative year-over-year earnings growth."

The Google and Apollo examples illustrate a basic point -- you can profit from positive and negative earnings surprises. Attempting this tactic is fraught with danger, but with the right research and trading strategies, you can reduce the risks.

Making Money From Good News

To make money from what you hope will be a positive surprise, you can buy the stock before the earnings announcement and sell it afterward. If you had purchased 19 shares of Google stock for $10,260 at $540 a week before it announced and sold them on Oct. 15, you'd have made a pretax, precommission profit of $1,150.

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Obviously, the hard part is figuring this out ahead of time. But let's look at what clues one could have used to bet on a positive Google surprise. It had a history of mostly positive earnings surprises and it was gaining market share in its core business. For the last several quarters, Google has beaten Wall Street expectations with one exception. And before it announced earnings, comScore's September 2010 rankings -- released Oct. 13 -- reported that Google's so-called explicit core search market share -- from which it gets 95% of its revenue -- rose to 66.1% that month from 65.4% in August.

While none of this made a bet on a positive earnings surprise a sure thing, it certainly meant that it was worth doing more digging to lower the risk of a bullish bet on Google earnings. One might also have taken a look at earnings previews for Google, as well as trends in key drivers of its revenues, such as search volumes, advertising rates, and search advertising growth forecasts.

Making Money From Bad News

How can you profit from a negative earnings surprise? In the Apollo example, you could have borrowed $10,000 worth of the shares (200 shares) from a broker and sold them short a week before its negative news at $50 -- and bought back those 200 shares for $36.58 on Oct. 15. This would have given you a profit before taxes and commissions of $2,684 after repaying the stock loan to the broker.

Betting on a missed earnings announcement is generally more profitable if you're right, but it's also riskier. If an announcement is better than expected, the stock will soar and your broker will get very nervous about your ability to repay your loan. For example, Apollo actually beat expectations by a penny, and had historically beaten expectations by a bit over 1% each quarter. If it had raised its guidance, its stock probably would have gone up. In theory, the possible losses on short selling are infinite.

What might have encouraged you to bet on an Apollo earnings miss was word in June that a highly successful hedge fund manager was shorting the entire for-profit education sector, of which Apollo is among the leaders. As I wrote then on DailyFinance, Steve Eisman, who made money shorting the sub-prime mortgage market, was taking a short position on the industry because he suspected that the Department of Education would be tightening up rules on its key source of profits: risk-free (to educational institutions) loans made to students, many of whom don't graduate and find themselves unable to pay that money back.

Was there anything that indicated ahead of time that this quarter would be the one when Apollo would announce its bad news? If you had taken a look at this Oct. 13 earnings preview, you probably would have shied away from taking a short position in Apollo stock. But in retrospect, one might have noticed that the key factor in the negative surprise -- the timing of new DOE regulations -- was mentioned in the preview as being delayed from November 2010 to early 2011. But it was still anticipated to affect Apollo's revenue guidance.

Given the likely change in the political climate after the midterm elections, it's entirely possible that those new regulations will never be implemented, which could make Apollo Group a buy. This is another reason that shorting is a riskier way to play negative earnings surprises -- you can be right about the long-term outcome, but events along the way can make it very expensive to be wrong in the short-term.

Hedging Your Risk with an Option Play

Sometimes, it is better to make these short bets through options. For example, you could buy a put option for less money that gives you the right, but not the obligation, to sell the shares at a higher price than you think a stock will ultimately be worth. If your bet is wrong, you only lose the amount you paid for the put option -- rather than the unlimited amount you might have lost had you made a bad short-selling wager.

For a brief explanation about how a put works, let's turn to Wilmington Trust, a Delaware-based bank with a focus on wealth management for high-net-worth individuals and large institutions: "A put contract to sell 100 shares of a $60 stock for $60 in 30 days may cost $300 ($3 per put). If the price of the stock declined to $55 by the expiration date, the put contract could be sold for $500 ($5 per put) providing a profit of $200 ($500 - $300 = $200) -- a return of 67%." Of course if the $60 stock rose to $65 in 30 days, you would lose the $300 you paid for the put.

But since you wouldn't exercise the option to sell the shares at $65 in 30 days because it would be a money loser (the $5 difference between the market and exercise price), that loss would be less than the $500 you would have lost if you had sold the shares short (the $6,000 proceeds you made selling the shares short initially minus the $6,500 you had to spend to buy back the 100 share at $65 so you could repay the broker).

Expect more surprises ahead. After all, according to Investing Daily, of 30 companies that reported earnings in September 2010, "26 beat consensus expectations, and the average surprise was just under 10 percent."

For those investors unsatisfied with buy-and-hold, it may be worth looking to see what profits can be made from the surprises yet to come.