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Don't Be Surprised This Reporting Season by John Wightkin, Director of Equity Research Applications, Schwab Center for Financial Research September 15, 2009 Key points
Well, you've just experienced what's called a negative earnings surprise. In general, an earnings surprise can occur when a quarterly earnings report differs from analyst expectations. In the hypothetical example above, the 30% reported earnings growth was lower than the company's consensus forecast earnings growth (i.e. 40% growth), resulting in a negative surprise. Because surprises often produce sharp increases or decreases in a stock price, anticipating a surprise may boost your equity returns. How do you prepare? As we head into earnings season, is there anything you can do to prepare for these earnings surprises? Surprise anticipation sounds nice, but is it possible to forecast the unexpected? The good news is that what's a surprise to many investors doesn't have to be a surprise to you. Here's some help for this upcoming earnings season. Why surprises matter Today's stock price reflects the market's consensus expectations of future fundamentals—in other words, the market places a current value on a company's future profitability. Consequently, meaningful stock price changes occur when investor expectations change regarding a company's future. Therefore, earnings surprises—which by definition are unexpected—should move stock prices. In fact, we find the stock price usually adjusts in the direction of the surprise: It rises with a positive surprise (reported exceeds forecasted earnings) or it declines for a negative surprise (reported is less than expected earnings). One caveat with earnings surprises—don't assume that every positive or negative earnings surprise will affect a stock's price. There are other factors that can influence a stock's price at the time of an earnings surprise, including the company's guidance, whether the company also announced a sales surprise, sector/industry trends and general market conditions as well. Fundamental analysis can help investors anticipate the impact these additional factors may have on a company's stock price. What if you had perfect foresight? To quantify the value of an earnings surprise, we measured the potential returns an investor could have earned with perfect foresight of quarterly earnings surprises. Working with the top 1,500 stocks ranked by market capitalization, we divided this universe into five equal stock groups at the end of each calendar quarter based on the earnings surprise that occurred for the respective quarter. In our tests, we assume a company's earnings are known the last trading day of each quarter. However, in actuality, a company reports its quarterly earnings a month or two after the end of a quarter. Therefore, we're using a measure, at the end of each quarter, that hasn't yet been known by the market and therefore represents perfect foresight. At each calendar quarter, we also measured the subsequent three-month return for each stock in each group to gauge the benefit of this perfect foresight. We performed this simulated test from December 1989 through July 2009. In Chart 1, we show the percent of stocks that experience a negative or positive earnings surprise. We do not show the companies whose earnings equal analyst expectations. As you can see in the chart, it would be profitable knowing which stocks are going to report the largest earnings surprises. If it were possible in advance to buy the 20% of stocks with the most positive subsequent quarterly surprise, our tests indicate the portfolio would have outperformed the average stock return from our 1,500 stock universe by close to 4.7% each quarter. In contrast, a portfolio of the 20% of stocks with the most negative quarterly earnings surprise would have underperformed the average stock return by close to 4% on a quarterly basis. Unfortunately, in the real world, you don't know which stocks are going to have the highest earnings surprise. But if you did, imagine the profits you could earn. Chart 1: Percent of stocks with an earnings surprise  Click to enlarge image Source: Schwab Center for Financial Research. How Schwab Equity Ratings® can help Luckily, you don't need perfect foresight to benefit from surprise anticipation. Schwab research has found that companies that subsequently perform better or worse than current consensus expectations have some distinct traits, which we've imbedded in Schwab Equity Ratings (See "Schwab Equity Ratings Foundations" in the Read more box at top right). Hence, we believe Schwab Equity Ratings can be used as a sophisticated surprise anticipation tool as third-quarter earnings season rolls around. Indeed, using the same 1,500 stock universe, we show in Table 1 that A-rated stocks reported quarterly earnings above consensus forecasts 73% of the time in our simulated tests since December 1989, which compares favorably to 63% for the total universe. F-rated stocks beat consensus forecasts only 49% of the time. Perhaps more significant, F-rated stocks reported negative surprises at a rate (44%) almost double that of A-rated stocks (23%) and greater than the overall universe rate of 33%. Schwab Equity Ratings have displayed an ability to anticipate earnings surprises. Table 1: Percent of stocks with a quarterly surprise by Schwab Equity Ratings (top 1,500 by market capitalization)
How does this translate into returns for you? As shown in the simulated tests in Chart 2, A-rated stocks have outperformed the average stock (average return of all 1,500 stocks in the Schwab Equity Ratings universe) by close to 1% per quarter on a buy-and-hold basis since December 1989, while F-rated stocks have underperformed by approximately 2.8%. We believe surprise anticipation is a key reason for these return differences. Chart 2: Quarterly return performance  Click to enlarge image Source: Schwab Center for Financial Research. How to use surprise anticipation As we've shown, knowing which stocks are going to report the largest earnings surprises can be a profitable strategy. Using Schwab Equity Ratings may allow you to improve your chances of owning these stocks and also could enhance your returns. On the eve of another earnings season, you may want to take a minute to review your equity holdings. If you own any F-rated stocks, consider taking a look at A-rated stocks as replacement candidates that would warrant further research. You can use the online Schwab Portfolio Checkup to identify these candidates. If you're looking for a new purchase, consider A-rated stocks as you begin your research. Finally, to see a company's expected report date, the consensus earnings estimate, the most recent earnings surprises and many other data points related to a stock's earnings, estimates or its Schwab Equity Rating, see the company's Schwab Equity Rating report. To find it, log in to Research > Stocks, and type a ticker into the Research field near the top of the page. You can find the Schwab Equity Ratings report under Ratings Summary on the Summary page, or on the Reports tab. This report effectively summarizes and consolidates many of the most important data points you need to research a stock. Bottom line Successful equity research must be able to identify stocks that perform better than the expectations embedded in their prices at the time of purchase. If your stock picks experience positive surprises more often than negative surprises, you have a good chance to outperform the market in the long run. We believe using Schwab Equity Ratings as a guide can be a big step in the right direction. Important Disclosures Schwab Equity Ratings use a scale of A, B, C, D and F, and are assigned to approximately 3,000 stocks headquartered in the United States and certain foreign nations where companies typically locate or incorporate for operational or tax reasons. Schwab's outlook is that A-rated stocks, on average, will strongly outperform, and F-rated stocks, on average, will strongly underperform the equities market during the next 12 months. Schwab Equity Ratings are not personal recommendations for any particular investor. Before buying, investors should consider whether the investment is suitable for themselves and their portfolio. Schwab Equity Ratings should only constitute one component in your own research to evaluate stocks and investment opportunities. From time to time, Schwab may update the Schwab Equity Ratings methodology. Results from tests using Schwab Equity Ratings are based on use of historical model performance results that have certain inherent limitations. Unlike an actual performance record, simulated results do not represent actual investment performance or trading. No representation is being made that any investor will or is likely to achieve profits or losses similar to those shown. The results presented are for illustrative purposes only and should not and cannot be viewed as an indicator of future performance, as an indicator of the returns a Schwab client would have realized or will realize in relying on Schwab Equity Ratings, or as an indicator of how individual Schwab Equity Ratings are performing or will perform in the future. The information provided is for general informational purposes only and should not be considered as an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision. All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve. Past performance is no guarantee of future results. (0909-10268) Return to Top |
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