A forecast-based fundamentals screen based on identifying companies where the earnings and/or sales reported in a company's interim or annual report are not in line with analysts' earnings estimates. An upside surprise - where a company reports higher earnings than analysts predicted - has often been observed to trigger an increase in the stock price.
Analysts produce individual forecasts based on the company's prospects and trends in growth and costs before a company releases its actual earnings. If a company releases a number higher or lower than the consensus (a combination of all the released estimates), this is known respectively as a positive or negative surprise. Positive surprises often happen at the beginning of a turnaround, or a new growth cycle where sales start to accelerate beyond the historical rates, “surprising” the analyst community. As far back as 1968, academic studies have found a strong positive correlation between earnings surprises and stock returns, particularly if the stock reacted positively the day after earnings were announced.
The phenomena, known as "Post Earnings Announcement Drift" finds that these stocks tend to outperform the market for the next 6-12 months.This is generally attributed to the fact that analysts are slow to revise their forecasts and the market does not fully react to the information about future growth conveyed by the earnings surprises.
Definition of a Forecast Surprise Screen
The following illustrative Earnings Surprise Screen combines a number of the criteria used by researchers in this area – these elements could be combined to varying degrees.
- Utilities are excluded since their revenue growths are typically more predictable than those for industrial firms (financial firms are also excluded)
- A positive earnings surprise up 5% and above industry average
- A positive sales surprise up 5% and above industry average. This provides an added measure of reliability as it’s usually more difficult/unusual for companies to tinker with sales vs. earnings and because sales growth is seen as more sustainable than cost reduction.
- Trailing 12 months sales greater than £25 million – This helps ensure that the surprise isn’t large simply because it’s coming from a low base.
- Average daily trading volume greater than 100k & market capitalisation above £25 million - This eliminates small, thinly traded stocks to which investors are unlikely to pay much attention (Jegadeesh's work used a share price above $5).
- Market capitalisation below median – Research shows that large firms tend to adjust to surprises more quickly than small firms do (they have higher institutional ownership, so they are tracked by more analysts and portfolio managers who tend to act quickly).
Does it Work?
In a recent 2006 paper, “Revenue Surprises and Stock Returns”, Jegadeesh and Livnat looked at both earnings and revenue surprises. They found that, just as the top 20% of stocks in terms of upside earnings surprises outperformed the broader market by 3% over six months, the top 20% in terms of sales surprises outperformed by 2.6% and a cross sample of the two actually outperformed the market by 5.3% (i.e. over 10% annualized).
Research on the UK market found a similar premium for firms that meet or beat analysts’ forecasts (i.e. 2.1% - 2.4% vs. 2.3% in the US, and even higher for beating earnings expectations (7.7%+ vs. 3.4% for the US). However, the research found that UK investors place a much higher weight on forecast revisions than earnings surprises when valuing their investing firms, indicating that they do not fixate on earnings surprises.
"Earnings surprises appear to have positive and significant explanatory power for abnormal share return only after controlling for forecast revisions. This result indicates that UK investors are able to differentiate the information contained in forecast revisions and earnings surprises".
How can I run this Screen?
Another possible screen criterion that may be worth adding is that the standard deviation of estimates is below industry average. A low standard deviation means that analysts are tightly clustered in their view on what a company should earn, making a surprise all the more... well, surprising. In “Difference of Opinion and the Cross Section of Stock Returns”, Harvard Professor Scherbina reported a 9% increase in the returns generated by stocks with low vs. high estimate dispersion (this effect was most pronounced for small companies).
Another screening signal is to look for a series of earnings surprises, sometimes referred to as the "cockroach effect" (like cockroaches, you usually see more than one earnings surprise). A research paper "Small Trader Reactions to Consecutive Earnings Surprises" indicated that small traders show an increasing reaction after a series of positive earnings surprises. This means that stocks that are mainly traded by small traders (i.e. small caps for the most part) are likely to produce a bigger increase on the second and third consecutive earnings surprises. This pattern is however weaker for larger investors and almost inexistent for the largest traders, hence it is less likely to be relevant for large-cap stocks.
Watch Out For
One concern is that this well-reported phenomenon of a market reward to positive earnings may be be gamed by management teams. Because meeting or exceeding the market’s earnings expectation is seen as building credibility with analysts and investors over time, managers have strong incentives to walk down analysts earnings forecasts (forecast guidance) or to use their discretion to meet expectations (earnings management), hence the focus above on sales surprise which is more difficult to manipulate.
One thing to watch for is the reaction of the stock on the day earnings are released. If there is a positive surprise and yet the price of the stock still drops, it may reflect inherent weakness, news not yet released, or the fact that the stock has beaten the official estimate but not the "whisper number".
From the Source
For further background on earnings surprises, it’s worth reading the 2006 paper titled “Revenue Surprises and Stock Returns”, Jegadeesh and Livnat. Chapter 14 of Jack Gough’s excellent book, “Your Next Great Stock: How to Screen the Market for Tomorrow's Top Performers” (available on Amazon) also provides a good example of an earnings surprise screen. See also Choi, Young-soo, & Lin, Stephen’s 2006 paper, “The market premium to meeting or beating analysts’ forecasts: further evidence from the UK” usive Beta!
- Zacks: Betting on Earnings Surprises
- How to Perform Earnings Surprise Analysis
- Zacks: What is a Real Earnings Surprise?
- QuantShare: Two Consecutive and Positive Earnings Surprises
- The SmartMoney.com Positive-Earnings-Surprise Screen
- Differential Market Reaction to Revenue and Expense Surprise
- Earnings Announcements are Full of Surprises