Summary
- SWBI is a stock highly susceptible to big movements on earnings in both directions, but both probability and risk/reward favor the shorts now.
- I backtested holding SWBI over Q1 earnings reports and found that the short position is the logical choice for a directional play.
- SWBI investors would have more than doubled their ROIs by avoiding Q1 over the years, and thus - even for non-traders - this article is worth a read.
Note: Timing the Market subscribers got early access to this article.
Today, we are looking at taking a short position on Smith & Wesson ( SWBI ) over its Q1 earnings report.
Sentiment is quite low for Smith & Wesson, both because the stock has recently underperformed and because of the Democrats' anti-gun activities before the midterm elections. In particular, the AR-15-related subpoena against SWBI certainly raises costs for Smith & Wesson and makes investors increasingly wary against going long at this point. Long guns, which comprise about one-fourth of SWBI's revenue, are being threatened under the current political atmosphere.
For earnings trades, we generally want to be in the direction opposite to price movement but aligned with sentiment, as that is the direction that allows for larger movements, should we be right. The phenomenon, zoomed-in, is essentially panic-buying (or panic-selling) once earnings results prove that the selloff (or rally) into earnings was unjustified. This leads to large profits over earnings, provided we take the right position.
SWBI is a stock highly susceptible to big movements on earnings in both directions. Notice how the stock has jumped on earnings in the direction opposite to the lead-up over the past year or so:
Note that the earnings rallies tend to be short-lived. This is usually due to negative sentiment. Investors take profits during rallies because sentiment points to a negative outlook in the coming quarters. The earnings selloffs, however, tend to create breakaway gaps , creating new trading regions.
As we are taking a short position, this is good for us, as it allows us to recover losses quickly but hold gains over the long term. I backtested SWBI's reactions to earnings versus a null hypothesis of reacting as an average stock and found the following.
- SWBI underreacts to positive earnings.
- SWBI reacts as expected to negative earnings.
That is, investors engaging in profit-taking hold SWBI back from reaching the potential of its rally on good earnings. Yet investors react normally on bad earnings, cutting losses in proportion to the size of the earnings surprise and guidance updates.
So, while the second fact means that we cannot expect too much on the downside of this play, the first fact bolsters us from large upside losses. Of course, we can do even better in protecting ourselves via option strategies, which I will mention later.
Just as important as the risk/reward of our directional position is the probability of correctness. I backtested holding SWBI over Q1 earnings reports and found that the short position is the logical one. The short position profits 65% of the time and brings slightly larger average gains than the long position (about 8% larger).
Here is what you get holding SWBI over the month covering Q1 earnings:
While buy-and-hold brings large gains over time, exposure to Q1 brings large losses in 1/12th of the time. The downside exposure, measured in average drawdowns (AvgDD) is actually larger when holding just over Q1, and the max drawdowns are nearly the same. Clearly, SWBI investors should entirely avoid Q1 if they want to improve their ROI.
I actually backtested this to find that SWBI investors would have more than doubled their ROIs by avoiding Q1:
Moreover, the fundamental timing looks about right. Smith & Wesson runs a pretty cyclical business. For a lot of earnings trades, I like to get in via a fundamental metric that has been shown to have predictive power for the stock, namely the ratio of gross profits to assets (GPA), which is a measure of business efficiency. The cyclical pattern in Smith & Wesson's gross profits is visible when you look at the quarter-to-quarter change in this metric:
But we don't want to take a short position, necessarily, when gross profits are falling alone. We also want to see assets growing, as these two trends point to increasing inefficiency, which should lead to lower-than-expected EPS. Smith & Wesson is currently in the latter part of an asset growth cycle, which helps justify our short trade over earnings:
Overall, from the fundamental viewpoint, the statistical patterns, and the unfriendly political environment, SWBI looks to be a good short position over the company's Q1 earnings. I want to take a short position via an options strategy, as follows:
- Sell 1x Jan19 $17.50 call
- Buy 2x Mar17 $12.50 puts
The entire strategy only costs $125 at the time of writing and mimics being short 120 shares of SWBI; however, it comes with the same (theoretically unlimited) risk that comes with shorting shares. You can cap your losses at $340 if you remove the short call, but then the strategy only mimics holding 72 shares of SWBI. I think the short calls are sufficiently out-of-the-money to where you needn't worry, as SWBI would need to rise 31% on earnings to put the calls into the money.
Let me know your thoughts.
For further details see:
Smith & Wesson Q1: What To Expect