Second-quarter earnings season is just getting started and, between expectations for negative S&P 500 earnings growth and the fireworks coming out of Greece, there’s a good chances that investors will be especially skittish at the slightest sign of weakness.
But, investors need to do more than applaud strong earnings growth and panic at an earnings miss. One quarter doesn’t make or break a company. Building a strong business is a marathon, not a sprint … and building a strong investment portfolio is the same.
Investors should be especially cautious when there is extra pressure on corporate management to deliver strong earnings numbers. As I discussed in my Facebook tip of the week, if you want to be successful with any type of investing, you need to first understand its origins and goals. Whether you’re looking for stocks with low price-to-earnings ratios, low price-to-book ratios or high dividend yields, you need to also take a close look at the sustainability of the company’s earnings.
Once again, this is critical in any type of investing.
To that end, make sure corporate management isn’t simply using accounting gimmicks to meet earnings expectations. Similarly, when you hear about a stock that is rising because of a product that seems faddish or gimmicky – beware. Gimmicks are especially common in consumer stocks, where catchy marketing and hype are the norm.
Additionally, sometimes revenue growth (and, in turn, earnings growth) in a certain quarter is simply due to the acquisition of one big-name customer. If that’s the case, there’s good reason to think the growth rate will drop off in coming quarters.
Either way, seemingly strong earnings won’t do you any good if they can’t continue marching in the right direction. Also consider if customer churn is high for a company, as that’s a sign the product is a gimmick that gets customers in the door, but can’t keep them coming back — all sales and no substance.
In any of these cases, companies may resort to accounting tricks to make it seem like earnings are still growing. For example, a little digging can show whether growth on the bottom line is due to cost cutting, as opposed to organic sales growth. If that’s the case, keep in mind that cost cutting will only prop up those numbers in the short-term.
Make sure the bottom line of any company you invest in is poised to keep chugging higher consistently. No matter your investment thesis, earnings are a fundamental indicator of a company’s health and prospects. Just make sure you look beyond the mere earnings beat (or miss) and consider broader trends and longer-term sustainability before you decide to buy.
Hilary Kramer is the editor of GameChangers and Breakout Stocks Under $10.
