For small caps and growth stocks in particular, earnings announcements often send shares jumping around like beach balls. This latest earnings season was no different – over the last month several companies that I follow (and recommend as “buys”) fell more than 8% the day after releasing third-quarter earnings.
It can be difficult to be calm amidst a period of earnings volatility, especially when your stock tanks. But if you’re in the right stocks to begin with, this earnings volatility often amounts to a quick blip on the screen that represents an opportunity to purchase more shares at a short-term discount.
As I stated earlier, I find this volatility tends to be more severe with small caps and growth stocks. And time and time again these good stocks recover quickly and go on to generate huge returns for patient investors.
This is one of the reasons I always recommend that investors dollar cost average into an investment. This is especially important with volatile small caps since a 10% move, or greater, is often the result of just a few large investors moving money around.
Averaging into the position significantly decreases your risk of buying at the “wrong” time. Incidently, I also find the strategy helps investors take that initial plunge to buy a potential big winner, because buying half a position first feels a lot safer than an “all in all at once” investment.
Here’s an example of this strategy in practice. The stock is Datawatch (NASDAQ:DWCH), a microcap stock that is a play on Big Data. I first recommended the stock to 100% Letter subscribers in November 2012 at $17.75 when the stock was on a downtrend.
Unfortunately, that downtrend continued through the third-quarter 2012 earnings season, and even into the beginning of 2013. However, confident in my research, I sounded the rally cry for DWCH again in early March, 2013 and urged 100% Letter subscribers to add to their position.
Thus far, it has been the right call — based on the average cost of two such timed purchases subscribers are up over 100%.
Three common-sense guidelines helped us stick with DWCH. And these same simple tips can help you turn earnings volatility into 100% winner opportunities, too:
Lesson #1: Do your homework, then keep doing it because businesses often evolve quickly over time … or not. The only way you’ll know the difference, and be prepared to act, is if you stay on top of things.
Lesson #2: Small-cap stocks often trade in an inefficient market, where there is an imbalance between buyers and sellers. This alone is not cause for concern but rather an opportunity for astute investors. And it’s one of the reasons many chose to focus only on small-cap and microcap stocks where independent research is the only reliable way to gain a knowledge advantage over other investors.
Lesson #3: Volume matters. Understanding that volume and liquidity both affect stock price movements can help you get a good price. And it also helps you understand why a 10% move can mean absolutely nothing in the big picture with a quality small-cap stock. Remember to use limit orders, not market orders, to get the price you want.
Market volatility can be intense at any time of year, and especially so during earnings season. Maintaining discipline is the key.
These three common-sense tips can help you understand if your small-cap stocks are actually crashing or if they’re just bouncing around. I use them to help me emerge from earnings volatility with a stronger portfolio, and I think you can too.
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