No More Tears: A Post-Earnings Post Mortem on Johnson & Johnson (JNJ)

Dow component Johnson & Johnson (JNJ – 64.04) emerged as the unlikely hero of Tuesday’s session, with the blue chip racking up a gain of nearly 4% on the heels of its first-quarter earnings report. Net income dipped 23% year-over-year, but JNJ’s adjusted earnings of $1.35 per share comfortably surpassed analysts’ expectations. Plus, the company raised its full-year earnings forecast by 10 cents per share, to a range between $4.90 and $5.00 per share.

Of course, given the corporation’s long and storied history, this is hardly the first time that JNJ topped bottom-line earnings expectations. As recently as Oct. 19, 2010, for example, the firm’s quarterly profit of $1.23 per share was notably higher than consensus estimates for $1.15 per share. 

Nevertheless, Tuesday’s rally of 3.69% marked JNJ’s largest single-day post-earnings gain since April 2000, according to Thomson Reuters data. In other words, this was no ordinary upside surprise.

So, what’s the difference between an "oh, that’s nice" kind of upside surprise, and a "biggest post-earnings price gain in 11 years" kind of upside surprise? In the case of JNJ, the answer seems to be: low expectations.

As many investors — and regular Tylenol users — are probably aware, JNJ has been plagued by a seemingly endless string of recalls during the past year. In fact, as recently as early April, the stock was the subject of a blatantly skeptical Bloomberg BusinessWeek cover. With two of its ubiquitous Band-Aids plastered over the company logo, the cover read, "Ouch! After more than 50 recalls in 15 months, can Johnson & Johnson, ‘The Family Company,’ still be trusted?"

This bearish cover definitely made the email rounds here at Schaeffer’s, where — as contrarians — strongly opinionated magazine stories like this one are our bread and butter. We believe that by the time a story like this makes the cover of a national magazine, the trend is already (a) widely known, and therefore (b) pretty well accounted for by the market already. As a result, these cover stories can actually mark turning points in a trend, where bearish (or bullish) sentiment has reached such a climax that it’s virtually exhausted. This certainly seems to be the case with JNJ, as evidenced by Tuesday’s breakout gain.

However, not everyone was caught flat-footed by JNJ’s post-earnings pop. Todd Salamone, our Senior VP of Research, observed that this latest earnings event was one of the few this earnings season in which pre-earnings implied volatilities were higher relative to those ahead of the January reports, as measured by our Schaeffer’s Volatility Index (SVI) — which functions as a kind of equity-specific VIX, by measuring implied volatilities on near-term, near-the-money options. (The spike in implied volatility for JNJ in mid-March was the direct result of the general pop in IVs in the aftermath of the Japan disaster.) 

Unlike the take in Bloomberg BusinessWeek, though, options players weren’t betting bearishly on JNJ. Our review of Trade Alert data indicated that most of the front-month pre-earnings option activity took place on the call side with a heavy buy-to-open bias, and this bullish speculation seems to have been a key driver behind the spike in implied volatility. These expectations for a major upside move played out in the wake of JNJ’s quarterly report — suggesting that this was actually smart money at work, with options traders fading the negative headlines ahead of earnings.

As earnings season continues, it’s worth keeping these basic contrarian principles in mind. By measuring a stock’s sentiment backdrop (for which option activity very often provides major clues) just as closely as its technical indicators and fundamentals, you can identify situations where the prevailing conventional wisdom on Wall Street is behind the curve — allowing you to benefit from "unexpected" price swings like JNJ’s.

Elizabeth Harrow

Editor, Schaeffer’s Investment Research