[Beginner's Guide to Stock Market] Stock Price Outlook Rises on Expectations of Base Effect... Impact of Base Effect on Stock Prices

[Asia Economy Reporter Kwon Jaehee] As the third-quarter earnings season comes to a close, there is a term frequently found in securities firm reports. You may have seen the term 'base effect' at least once. Let's find out what the base effect is and also what the 'reverse base effect' means.

HiteJinro Achieves Strong Performance but Leaves Some Regrets; Next Year’s 'Base Effect' Is Expected

In the third quarter, HiteJinro recorded sales of 657.4 billion KRW and an operating profit of 57 billion KRW. This represents increases of 17.9% and 27%, respectively, compared to the same period last year, and aligns with market consensus. However, unexpected one-time expenses also increased.

Sanghoon Cho, a researcher at Shinhan Investment Corp., analyzed, "Due to added labor and transportation costs related to the Cargo Solidarity strike, labor costs from collective bargaining, and advertising and promotional expenses, the company could not fully enjoy the leverage effect from increased sales, which is regrettable. However, this will rather act as a base effect next year."

What Exactly Is the Base Effect?

As seen in the HiteJinro stock report earlier, the base effect refers to the phenomenon where if last year's or the previous quarter's performance was poor, even a slight improvement this year or this quarter feels like growth. For example, if South Korea's economic growth rate was negative last year but is 0% this year, it is not actually growth, but it appears as if growth has occurred.

The same applies to corporate earnings. Suppose there is a company A that consistently earns 10 billion KRW in profit every quarter. If this company earned 5 billion KRW in the previous quarter and then returns to 10 billion KRW this quarter, compared to its usual 10 billion KRW profit, it is a normalization, but compared to the previous quarter, it looks like more than double growth. This is called earnings growth due to the base effect.

[Image source=Yonhap News]

Then What About the Reverse Base Effect?

By now, you might have a rough idea about the reverse base effect. That's right. It is the opposite of the base effect. It refers to the phenomenon where, despite recording good earnings this quarter following an exceptionally strong previous quarter, the performance is undervalued because it did not grow compared to the previous quarter.

Assuming that 5 billion KRW is the industry average earnings, if company A recorded 10 billion KRW in the previous quarter and 7 billion KRW this quarter, company A achieved earnings above the industry average, but compared to the previous quarter, it appears as if it did not grow. This is called the reverse base effect.

So How Does This Affect Stock Prices?

[Image source=Yonhap News]

As investors, rather than just the meaning of the terms themselves, we need to look at how these affect stock prices. As you know well, stock prices move due to various factors. One of these is market (investor) expectations.

If a company records good earnings but there are concerns that it will not be able to maintain such performance next quarter, stock prices may fall.

There is an actual example. One of the industries that performed well during the COVID-19 pandemic was the food and beverage sector. Since dining out was restricted, ready-to-eat meals at home became very popular, and CJ CheilJedang, a leading food and beverage company, recorded significant profit growth. CJ CheilJedang, which usually earned about 270 billion KRW in profit per quarter, saw operating profits of 385 billion KRW and 402 billion KRW in the second and third quarters of 2020, respectively, during the COVID-19 outbreak, greatly increasing earnings. However, stock prices showed a sluggish trend in the second half of 2020 because there were concerns that next year's earnings would fall short of these record-breaking results caused by the special circumstances of the pandemic.

Stock prices move due to various factors. Stock prices may rebound due to the base effect or temporarily fall due to the reverse base effect. But what is important is not these 'optical illusions' but the ability to identify growth stocks that consistently generate profits. We hope you become investors who can see beyond the numbers, not just play with them. We support the wise investments of all beginner investors today as well.

Editor's Note[Beginner Investor's Guide] is a smart investment guide for 'Joorini' (stock + child). We will kindly and easily explain unfamiliar stock stories to beginner investors.