Since both positive and negative earnings surprises—that is, reported earnings above or below analyst expectations—can have lingering long-term effects, tracking revisions made by analysts is a rewarding investing strategy. AAII has created four screens that look for earnings estimate revisions: one that looks for upward revisions in annual earnings estimates; one that screens for companies with downward revisions; one that screens for companies that have had at least a 5% increase in annual earnings estimates over the last month; and, finally, one that screens for companies that have had at least a 5% decrease in annual earnings estimates over the last month. AAII’s Stock Investor Pro contains consensus earnings estimates from LSEG I/B/E/S and is used to perform our screens.
In this article I discuss the strategy that focuses on firms with at least a 5% increase in annual earnings estimates over the last month. AAII’s Estimate Revisions Up 5% screening model has an average annual gain since inception (1998) of 20.6%, versus 5.8% for the S&P 500 index over the same period.
Current Trends In Earnings Estimate Revisions
Companies in the S&P 500 have seen both earnings and revenue grow at a slower rate in 2023, with full-year earnings expected to increase 2.4% and full-year revenue expected to increase 2.0% according to LSEG I/B/E/S. Analysts are expecting double-digit earnings growth of 12.1% for the S&P 500 in 2024. The energy sector is dragging down the revenue and growth rates; excluding the energy sector, the expected full-year earnings growth rate sits closer to 5.7% and the expected revenue growth rate is 4.7%.
The Impact Of Earnings Surprises
Expectations play a key role in determining if a stock’s price rises or falls when actual earnings are reported. Investors quickly learn that the market is forward-looking. Security prices are established through expectations, and prices fluctuate as these expectations change or are proven incorrect.
There are several services that track and analyze expected earnings estimates. Services such as LSEG I/B/E/S and Zacks Investment Research provide consensus earnings estimates by tracking the estimates of thousands of investment analysts. Tracking these expectations and their changes is an important and rewarding strategy for stock investors.
In using earnings estimates, the first rule to keep in mind is that the current price usually reflects the consensus earnings estimate. It is common to see price declines for stocks that report earnings increases from the previous reporting period because, in many cases, while the actual earnings represent an increase, the increase is not as great as the market had expected. Earnings surprises occur when a company reports actual earnings that differ from consensus earnings estimates.
Most companies announce earnings approximately one month after the end of the quarter. During the earnings reporting season, business news channels and financial websites provide daily reports on earnings announcements. Firms with significant earnings surprises are often highlighted.
Positive earnings surprises occur when actual reported earnings are significantly above forecasted earnings per share. Negative earnings surprises occur when reported earnings per share are significantly below earnings expectations. The stock prices of firms with significant positive earnings surprises show above-average performance, while those with negative surprises have below-average performance.
Changes in stock price resulting from an earnings surprise can be felt immediately, but surprises can have a long-term effect. Studies indicate that the effect can persist for as long as one year after the announcement. This means that it does not make sense to buy a stock after the initial price decline from a negative earnings surprise. There is a good chance that the stock will continue to underperform the market for some time. It also indicates that it may not be too late to buy into an attractive company after a better-than-expected earnings report is released.
Unsurprisingly, large firms tend to adjust to surprises more quickly than small firms do. Larger firms are tracked by more analysts and portfolio managers, who tend to act quickly. Firms with a significant quarterly earnings surprise also often have earnings surprises in subsequent quarters. When a firm has a surprise, it is often a sign that similar surprises will follow.
Since both positive and negative earnings surprises have lingering long-term effects, a rewarding investing strategy is one that avoids stocks you believe will have negative earnings surprises or that have had negative earnings surprises. Selecting positive earnings surprise stocks before and even after the earnings come in may be similarly profitable. Even a strategy of simply selling after negative earnings surprises and buying after positive earnings surprises probably has some merit.
Stocks With Upward Revisions May Outperform
Revisions made by analysts to earnings estimates lead to price adjustments similar to those of earnings surprises. When earnings estimates are revised significantly upward—5% or more—stocks tend to show above-average performance. Stock prices of firms with downward revisions show below-average performance after the adjustment.
Changes in estimates reflect changes in expectations of future performance. Perhaps the economic outlook is better than previously expected, or maybe a new product is selling better than anticipated.
Revisions are often precursors to earnings surprises. As the reporting period approaches, estimates normally converge toward the consensus. A flurry of revisions near the reporting period can indicate that analysts missed the mark and are scrambling to improve their estimates.
Companies like to report positive earnings surprises, so it is not surprising that many companies try to “manage” the estimates slightly downward to create a positive surprise. Studies show that, on average, there are more positive quarterly surprises than there are negative surprises. Interestingly, estimates for the fiscal year do not tend to show the same positive surprise bias.
Screening for Earnings Estimate Revisions Up 5%
AAII’s first filter eliminates those firms with less than five estimates for the current fiscal year. This filter helps to ensure that revisions actually reflect a change in general consensus, not just a change by one or two analysts. However, requiring a stock to have at least five analysts reporting earnings estimates will knock out most of the smallest-cap stocks.
The number of estimates for each firm is provided to help gauge the interest in the firm and the meaningfulness of the overall estimates. The larger the firm, the greater the number of analysts that will track it. The number of upward revisions indicates how many analysts have revised their estimates upward in the last month. When compared to the number of analysts making estimates, this confirms the significance of the percentage change in estimates. You can put more faith in a revision if a large percentage of the analysts tracking a firm has revised their estimates.
The next filter requires that the firm has an upward change over the course of the last month in its consensus estimates for the current (Y0) and next (Y1) fiscal year. We are also screening to make sure that analysts have not lowered estimates for the current or next fiscal year during the past month. Naturally, we also look for those companies that have had at least a 5% increase in the current and next fiscal-year earnings estimates over the last month.
Changing Expectations Drive Stock Prices
Earnings estimates are important. They are a numerical view of expectations, and changing expectations drive stock prices. If you are investing in individual stocks, a few points on earnings estimates are worth keeping in mind:
- Know the consensus earnings forecast of a stock you own or are interested in.
- Realize that the stock price already reflects the consensus about future earnings. Be aware that, if a stock is highly touted, the basis for the recommendation should be an earnings forecast by analysts significantly above the prevailing opinion.
- Before investing, ask for and carefully evaluate the foundation of an earnings forecast that deviates substantially from the consensus.
- Significant earnings surprises, positive or negative, probably have a long-term effect on a stock’s price, as analysts revise long-term earnings forecasts accordingly.
Stocks Passing the Estimate Revisions Up 5% Screen (Ranked by Current-Year Revisions Made Last Month)
For more on this topic, join the AAII Stock Screening Community and check this out, as well as other conversations on using stock screens.
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The stocks meeting the criteria of the approach do not represent a “recommended” or “buy” list. It is important to perform due diligence.
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