How to Approach Earnings Season

 | Oct 10, 2012 | 2:30 PM EDT
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Last night, Alcoa (AA) kicked off earnings season, and most of the Street is hanging on every world of the conference call for some guidance on the state of the world. I cannot imagine a more overrated and futile exercise.

Alcoa may provide some insight into how Alcoa is doing, but its report will have very little to do with the direction of earnings season. Many analysts believe that third-quarter earnings are going to be horrible. A few optimists say that bad expectations are overdone and that we will surprise to the upside this quarter. I have no idea, and I really don't want to spend much time thinking about the matter.

An enormous amount of time and energy is going to be spent trying to predict and profit from earnings reports over the next several weeks. Over the course of my career, I have met a few traders such as Tim Collins and Bob Lang who make some money doing earnings trades. But the vast majority of folks I have seen try to trade earnings have left the arena on their proverbial shields.

Structuring a trade that correctly predicts earnings and the short-term market reaction requires a high level of statistical, economic and psychological expertise that is beyond my skill set and I suspect that of most part-time traders.

My approach to earnings season is based on reacting, not predicting. I am going to be watching for any of my holdings that post a huge upside surprise and are bid up to the point where valuation suggests that selling is the right course of action. I will be keeping an eye of my watch lists of banks and infrastructure stocks in hopes that they disappoint the always-highly-accurate Wall Street analysts and fall to the point where they are cheap enough to buy.

I also have my list of Schlossian stocks on my screen. I ran a screen to look for stocks that are trading at or below tangible book value and have low debt and high insider ownership. I also want these companies to either be profitable or be expected to be profitable next year. I will be watching these companies in hopes that they disappoint investors while still showing a profit and that their shares tumble as a result. Earnings season can often provide an entry point for my lists of not-quite-cheap-enough stocks.

One of the stocks on my list is an old favorite. I purchased West Marine (WMAR) back in 2008 as one of my "addictive lifestyle" stocks. The stock quickly doubled in the market recovery, and I scaled out of most of my stake in the company. I still have a little on the sheets but would love to buy more on an earnings-inspired selloff later this month.

The company has seen revenue rise for four quarters in a row. Margins have expanded as the company has focused on the sales of boating-related apparel. West Marine has closed its smaller, marginally profitable stores to focus on larger flagship locations, and that has helped drive the top and bottom lines as well. The economy is not strong enough to drive full-fledged recovery in the boating industry, but this business will recover at some point, and this company will be a huge beneficiary. The stock is trading at 90% of tangible book value, and I would love to see a steeper discount as a result of a slower-than-expected summer season.

One stock that makes my list is one I would love to own. Right now, Zoltek Companies (ZOLT) trades right at tangible book value. The company is primarily thought of a play on wind power, as its carbon fibers are used in the manufacture of wind turbines. While this is definitely the case, the company also sells to the aviation industry and to auto companies, and its products are used in construction components and natural gas storage tanks. This is a solid business with a potential "green energy" kicker, in my opinion.

The expiration of tax credits at year-end could delay some orders as investors wait for election results to see if the U.S. credit is restored. I am hopeful that this causes management to guide lower for the rest of the year and gives me a chance to buy the stock on the cheap. Zoltek does not report until December, so unless it preannounces, I will have to wait a little bit for a potential earnings-related selloff.

Gambling on the outcome of a three-month period in a corporation's life and the market's immediate reaction to the news is a difficult game for most investors. The key to earnings season for long-term investors is to react, not predict.

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