Being a Weather Contrarian

Every year when the forecasts for the hurricane season are issued, there have been a spate of articles on implications for investors.  This year was no exception.  USA Today reported that U.S. natural gas prices jumped 3% on the basis of a forecast for an active hurricane season in 2013.  It is also common to read that companies are attributing poor earnings to unusual weather.

Unusual seasonal weather conditions impact many businesses.  Canadian National Railway Company (CNI) management points to a harsh winter as the cause of a major year-on-year drop in profits.   Relatively colder conditions for the first quarter of 2013 have negatively impacted McDonalds restaurant sales.  Air Canada, Canada’s largest airline, also just reported operating income well below expectations due largely to adverse weather conditions.   The company’s stock price collapsed 12% after the announcement.

Even Caterpillar’s recent earnings surprise has been blamed partly on the colder winter.

Utilities are the companies with the most direct connection between earnings and weather.  Colder winters and warmer summers lead to higher energy demand by consumers and tend to boost utility earnings.  Similarly, weather can have a big impact on companies in the agricultural sector, including food producers and their suppliers, although the amount of a food commodity in storage can mute the response of commodity prices to weather.

Property and casualty (P&C) insurers also experience a direct connection between weather and their earnings.  Travelers (TRV), for example, paid out far less for covered natural disasters in Q1 of 2013 than the company paid in same period of last year, which directly helped their bottom line.  TRV’s stock price jumped 3.9% after earnings were announced.

I have observed this pattern over and over again through the years.  It makes sense that lower-than-expected earnings announcements tend to drive a stock’s price down because investors interpret low earnings as due to either worsening conditions for the business as a whole or poor management.  Either way, this is bad news.  What makes weather-driven earnings surprises unusual, however, is that they are most often due to chance and are not more likely to recur on the basis of the previous period.  Selling a stock because adverse weather drove down earnings in the previous quarter is truly like closing the barn door after the horse is gone.  For this reason, I am something of a weather contrarian: I tend to buy stocks after their prices have declined due to weather-driven earnings surprises.

There are important caveats to a contrarian weather strategy.  First, even though an earnings surprise is attributed to the weather, this true impact of weather is hard to parse out.  As a manager, I’d much prefer to blame bad weather than poor executive decision making for a bad quarter.  Second, there are weather anomalies that do persist so simply betting that things will return to normal is not a good idea.  Droughts, for example, tend to persist for long periods of time and drought conditions often correspond to persistent hot weather.  As the ground dries out, there is less evaporative cooling.  Similarly, weather anomalies caused by El Nino can persist for extended periods of time.

Being a weather contrarian simply means that you recognize the transient nature of weather-driven earnings surprises.  The fact that a mild hurricane season causes a surprise increase in the earnings of a property and casualty insurer does not make me think that the company’s management or business model is superior.  Low earnings from a utility due to a warm winter has no impact on my long view of the attractiveness of the company.  My overall thesis with regard to weather is simply that weather-driven earnings anomalies are often one-off events as opposed to more systemic earnings drivers.  Long-term investors will do well to distinguish between the two.  When a company comes out with lower-than-expected earnings due to extreme weather, this is a buying signal for weather contrarians.  Conversely, weather contrarians will avoid buying stocks in the aftermath of a positive earnings surprise that is largely due to fortuitous weather.

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