Wednesday, February 27, 2008

When "No News Is Good News"

Today I'm reminded of the importance of having a well-defined investment decision-making process. Equally important is to be disciplined by abiding with the investing rules that we have established for ourselves. That's not to say that we should be rigid in our investing approach and never modify our process. To the contrary, we are constantly testing and analyzing our approach and seeking modifications (tweaks if you will) that will further improve our processes. But at any given moment in time, we should follow the rules we have established for ourselves in making our covered calls investing decisions.

One of the tenets of the Covered Calls Advisor is to try to avoid investing in any company whose earnings will be announced prior to the options expiration date. Since this advisor sells near-month covered calls, it is not difficult to find numerous good companies to purchase that meet this criteria. Often, a quarterly earnings announcement will surprise investors and cause a quick and large price movement in the stock. Any surprises (especially negative news) that trigger dramatic stock price moves are anathema to the covered calls investor. So, to avoid the potential substantial declines that sometimes result from negative earnings surprises, why not negate this possibility by simply not buying any company with an earnings release prior to the options expiration date?

As covered call investors, the majority of our return-on-investment comes from the decline in time value of the options sold. A company with less stock price volatility is much preferred to one with a highly erratic (especially a declining) stock price. In this regard, earnings news often increases a stock's volatility -- so since we have the opportunity to invest in companies for time periods during which they will not make an earnings announcement, then we should consider doing just that. Earnings news provides both positive and negative surprises, neither of which is desirable for the covered calls investor. By avoiding earnings releases, we give some credence to the adage -- "No News is Good News".

This month for example, one company that met all my criteria (except one) as a good covered calls investment candidate was Autodesk (ADSK). Most importantly, ADSK had a 'Buy' rating from both of my preferred stock selection advisors (Schwab Equity Ratings and MarketGrader.com). By the way, Goldman Sachs, Argus, Standard & Poor's, and Reuters all also had 'Buy' ratings on ADSK. It also earned a very high overall rating on my 'Analysis Sheet' when all the additional factors were entered there. However, I decided against taking a March '08 covered calls position in ADSK for the one and only reason that their quarterly earnings release would be on Feb.27th (i.e. prior to the Mar08 options expiration date).

Today, because of Autodesk's earnings announcement, I'm very pleased that I have the no-earnings-release criterion and that I maintained sufficient discipline and abided by that rule. Investors were disappointed today when ADSK announced earnings that were below analysts' expectations. The stock was pummeled (down 15.6% from yesterday's $39.10 closing price to $32.99 at today's close). This example today has confirmed two important investing principles for this advisor, namely:
1. Have a well-defined investment decision-making process; and
2. Stay disciplined by following that decision-making process.

Regards and Godspeed,

1 comment:

  1. Been lurking here for awhile..

    I created my own methodology for choosing stocks to cover. Solid companies with strong earnings, low volatility with a dividend as a bonus. I take the list of candidates and plug them into my "optionator" spreadsheet to evaluate potential returns (ARIE, etc...). Similar to your philosophy I evaluate whether to roll-up, dump-it or let it exercise.

    I didn't include the earnings date in my stock choosing process, but will add that as an important criteria in the future. It may be difficult to avoid earnings announcements on all stocks since some stay in the portfolio month after month...

    Great blogsite and keep your thoughts posted regularly...

    ReplyDelete