Connecting on an Earnings Miss

 | Jan 31, 2012 | 12:30 PM EST
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I have been studying earnings surprises for decades now. I am a bit of a geek and have always spent time plowing through academic articles and research for ideas and insights into finding stocks that will outperform.

There is a ton of research by Professor Lawrence Brown of Georgia State University, Richard Mendenhall of Notre Dame, as well as non-academics such as Louis Navellier, that support the idea that stocks with positive earnings surprises outperform the market for certain time periods. Being me, I have had to stand that on its head and look at the idea from the other side. Much as a positive earnings surprise can push a stock higher, a negative surprise can create a severe overreaction and pushes the stock lower. Often the selling goes too far and creates an opportunity for contrarian traders and value investors like me.

Even in a quarter of lowered expectations we are seeing some stocks get punished for missing the always-highly-accurate earnings estimates of Wall Street analysts. One of these severely punished stocks is one that I have followed for a while and sold options on form time to time. Radio Shack (RSH) preannounced what is simply a terrible quarter yesterday. The company announced that earnings would be between 11 and 13 cents a share, far less than the anticipated 36 cents a share in the quarter. Discounting and changes in upgrade policies by Sprint (S), a major vendor, appear to be the chief culprits of the expected decline. The company will report earnings on Feb. 21 and it will be the fifth consecutive negative surprise for the company.

This inability to meet Wall Street's expectations has been reflected in the share price. The stock got into the low 20s last year on rumors of a private equity bailout, but is going to open at about a third of that level this morning. Radio Shack shares are trading this morning for less than tangible book value and the selloff may have created a bargain. The transition away from T-Mobile and Wal-Mart (WMT) hurt the company, but offering Verizon (VZ) and Sprint products at kiosks in Target (TGT) should eventually help revive sales for the chain. The company will maintain the dividend providing a juicy 4.9% yield, but will suspend share buybacks to preserve cash. The stock is probably worth an initial position here and more aggressive investors might keep an eye on the April $6 and $7 put options for an opportunity to back into the stock.

Heartland Financial (HTLF) reported earnings that fell short of estimates by 2 cents a share. This marks the fourth negative surprise in the prior five quarters for the bank. I am hoping Wall Street notices and punishes the stock over the next week or two. The bank currently trades just over tangible book value and if it falls to a discount I will back up the truck and add this one to my trade-of-the-decade portfolio. Heartland has seen non-performing loans continue to fall. Those are now less than 3% of the total loan portfolio. They are among the banks that used the treasury Small Business Fund to repay TARP and this should lead to a large improvement of the bottom line for the bank. The tangible equity-to-asset ratio is at the low end of my range but this bank should do very well in its Midwestern and Western markets going forward.

Popular (BPOP) is one of my long-shot banks that missed earnings during the past week. Although they fell short of the estimates, the Puerto Rican bank holding company did report a profit compared to a loss a year ago. The bank had its first full-year profit since 2006 as it continues to work to improve loan quality and put the credit crisis behind it. The stock has an equity-to-assets ratio of 8.62 and trades at about half of book value. The recent pullback gives long-term aggressive bank stock investors a chance to add this bank to their long-term long-shot portfolio.

Earnings misses are not talked about as much as their positive cousin as a source of potential profits, but sometimes a swing and a miss sets up the home run.

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