- A company sells a portion of its ownership in return for raising capitol (money) for investing in expanding their business. In return for giving the company money, the buyer is given stock.
- The buyer then hopes other buyers will want to buy their stock from them for more than they originally paid for it a.k.a. the stock price will increase.
The stock price is driven by many factors, but one of which is how well the potential buyers predict the company is going to do financially.
If the company performs better than the public expected it to, then the price typically rises. If the company performs worse than expected, then the price typically drops.
Companies report their fiscal performance quarterly and therefore, there are four times a year when you can see a drastic rise or fall in stock prices. There are certainly other times when this can happen, but around earnings reports is relatively predictable.
**Before I continue, please note that this is not a post about stock fundamentals, choosing solid companies, or discussing different investment strategies such as buy and hold versus day trading. Those are all concepts that affect how you buy stocks, when you sell them, and how you should approach earnings reports – but are for another day. This post is simply an introduction to why and how those reports may affect stock price.
CAT as an Example
As you know, I purchased CAT (Caterpillar) a few months ago as part of the Wealth Building Account portfolio. Since that time, the stock price has varied between $115 and $94 with it sitting right around $105 today.
However, last week the stock price rose to hover right around $112, but then the quarterly earnings reports were released on Friday and the price immediately dropped 7 points.
Why did this happen?
Investors (potential buyers) anticipated that CAT’s report would be better than expected and therefore started buying up stock in anticipation of the price rising when the report was released. The price went up during this buy up because more people wanted the stock and so competition drove up the price (supply and demand concept).
On Friday, the report was not as good as expected and therefore investors sold off their stock as quickly as possible to avoid the price plummet – but the sell off is what caused the price drop. Do you see the circle? By the way, the CAT 5 day stock price is shown in the graph above.
**These are my personal observations and I want to remind you I am not a trained financial expert.
- There is money to be made around the release of quarterly reports. You should know exactly when those releases will be made for any stock you own or are contemplating purchasing.
- If you could predict the report results and sold CAT on Thursday you would have made an immediate 6% return on investment. A strategy may be to hedge your bets and buy/sell opposite of what public opinion believes to be true. Why would you want to do this? Well if they were right, then if you sold and the price went up, it likely wouldn’t have gone up drastically because everyone already assumed it was going to go up so you wouldn’t have “lost” much money. But when they were wrong and it drops, you make money.
- I’ve also noticed that stocks tend to have an immediate reaction to an earnings report and plummet, but the following few days they tend to rebound. For example, CAT is up a point already today which translates to 1% return on investment in less than 12 hours. I’ll pay attention to see what happens later this week. A strategy would be to purchase stock at it’s low point the day it plummets (or the opening price the following day) and hold it while it rebounds then sell. This is more of a day trader strategy.
There are many other things to consider such as the trading fee ($10 per trade on $1,000 invested negates a 1% increase) and dividend yields (CAT pays 1.75% dividends), but recognizing this is a simplified means of looking at the situation, I am still intrigued by how I can use these observations to make some money.
What do you think? Have I oversimplified? Or is there something to it?