Friday, June 18, 2010

Bouncing Off Bad News

When a stock's earnings reporting date nears, its volatility can increase as anxious investors start betting on whether the past quarter was kind to the company. Some earnings misses can result in double-digit drops to a company's stock price, while earnings beats have the potential to be huge boosters for stock prices. Investors, of course, can't tell in advance whether an earnings report will deliver good news or bad news; nevertheless, the investor can put himself in a position such that he is somewhat protected from downside events.

Consider New Frontier Media (NOOF), a company we have previously discussed as a potential value investment. Last week, the company reported earnings which missed expectations, amidst a slew of write-downs, asset impairments and restructuring charges. Nevertheless, the stock price actually rose following the news, as investors did not rush to beat the stock down.

So what happened...did nobody know about the earnings release? After all, it is a small, little-followed company. That doesn't appear to be the case, as volume was three times normal, suggesting investors were acting, but they just weren't selling the stock off.

Why might this be? The company's valuation. When you're trading at five times cash flow (or three times cash flow once the effect of the company's cash balance is subtracted from its market cap), there isn't much further its price can fall. On the other hand, when a stock with huge expectations (e.g. a stock with a high P/E) misses its target, the stock price tends to take a huge hit.

But while this phenomenon can be found by observation, its results are based a little too much on one's own personal experiences which can then be affected by our personal biases. For this reason, in tomorrow's post we discuss a study which identified the responses of US stocks to both positive and negative surprises after dividing them into quintiles based on their P/E or P/B ratios. David Dreman explores this topic in Chapter 6 of his book, Contarian Investment Strategies.

Disclosure: Author has a long position in shares of NOOF

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