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The Earnings Surprise Strategy

Hedge-fund managers in the UK and around the world sometimes use a blue chip share strategy that focuses on one of the most closely analysed aspects of corporate performance: profits, also known as earnings. In simple terms, many managers bet big on a company ‘surprising’ the market with profits that are in excess of the estimates suggested by the so-called consensus of market analysts and researchers.

The earnings surprise factor simply measures by how much a company’s reported earnings differ from expectations, relative to the stock’s price. The factor is quantified as follows, where EPS means earnings per share:

(Reported EPS – Expected EPS)

No set number constitutes an earnings surprise, other than the fact that it isn’t within the expected consensus estimate. Often this surprise leads to a sharp reaction in the share price, which is also dependent on how closely the stock is followed by analysts and the public at large.

The market often under-reacts to meaningful changes in corporate fundamentals in the short run, leading to subsequent earnings surprises and price drifts in the direction of those surprises. In other words, the share price pretty much constantly rises over the months following an earnings surprise.

Locate earnings estimates

Most investors — hedge fund or otherwise — tend to rely on the profits estimates that stockbrokers or sell-side analysts (analysts who research and evaluate companies for potential earnings growth in order to make recommendations to the brokerage firms for which they work) and researchers provide.

Yet these analysts don’t produce their numbers in a vacuum — their estimates are influenced by the projections provided to them by company management. Corporate executives use these projections to provide a basis to explain to the analysts how they anticipate their company performing in the future. From there, the analysts layer in some of their own assumptions in order to create an independent earnings estimate.

Understanding the dynamics of this relationship and the vested interests is crucial:

  • Company executives: It’s not in the interests of the corporate executives to produce massively volatile earnings, especially because their bonuses are usually tied to those actual profits. They like to smooth out profits and generally show to analysts that their company is trending positively.

    Therefore these projections may be fairly conservative in their nature — a massive downturn doesn’t earn a finance director any plaudits whereas a pleasant upside surprise can trigger a massive payment.

  • Analysts: Clients act on a stockbroker analyst’s recommendation only if they think that the advice is going to help them make money. The more money a firm’s clients make from a particular analyst’s recommendations, the more valuable the analyst is to that firm.

Crucially the number of buy notes vastly outnumbers the amount of sell notes (that is, analysts tend to write more positive, or bullish, reports than negative, or bearish, ones), resulting in a constant push to be positive and optimistic. Analysts at US research service Zacks note that:

The incentive for issuing conservative earnings estimates is that the company has a better chance of reporting earnings that exceed forecasts. In turn, clients will be happy to see the stock’s price rise. Conversely, there is no incentive to issue an earnings forecast that is overly optimistic.

Equally, according to Zacks.com, missing a forecast estimate by analysts is ‘the most dreaded outcome, since it suggests that a company is not performing as well as investors thought’ and a ‘stock’s price will often tumble in response to an earnings miss’.

Find the biggest opportunity

In 1979 Leonard Zack (of Zacks.com) looked at the slightly peculiar world of earnings surprises and disappointments and found that:

The stocks most likely to outperform are the ones whose earnings estimates are being raised. Similarly, the stocks most likely to underperform are the ones whose earnings estimates are being lowered.

Analysts have since honed their understanding of what constitutes the perfect earnings surprise strategy. Here’s the practical, no-nonsense advice from Zacks.com of what an investor should do:

  • Start by looking for stocks with a minimum 100 per cent earnings surprise where the reported earnings are at least double the consensus (average) analyst forecast.

  • Not focus on companies that routinely surprise but instead look for real surprises where the company hasn’t reported consistent positive surprises in previous quarters.

  • Disqualify stocks if the company’s guidance for future growth isn’t consistent with the just-reported results; that is, it has been fibbing about past failings and successes and has now moved the goalposts.

  • Understand that the biggest opportunity is probably in smaller stocks because they’re more likely to surprise and to be poorly researched by institutional analysts.

  • Look for a big price move after an earnings surprise.

  • Be sure that trading volume is up substantially following the positive news.

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