Earnings Are Better Than Expected, but Look Beyond the Surprises

Second-quarter earnings season has so far exceeded expectations by a higher margin than we’ve recently seen. Refinitiv says 78.6% of S&P 500 index companies have topped expectations, “the highest beat rate” since the third quarter of 2021. The magnitude of positive surprises, at 7.7% above expectations, is also the largest since the third quarter of 2021.

While whether a company beats, meets or misses expectations influences how investors react to earnings, it is only one part of incorporating earnings estimates into a strategy.

Let’s start with the basics. Earnings estimates are forecasts made by analysts about how much a company will earn over a given quarter or year. The consensus estimate is the average of all the analysts’ forecasts made for a given quarter or year. Changes in consensus earnings estimates are a driver of stock prices. Earnings estimates that are revised upward are a catalyst to drive stock prices higher, while earnings estimates that are revised downward are a catalyst to drive stock prices lower or at least underperform.

An earnings estimate that differs from reported earnings at the time of release is called a surprise. The price reaction following an earnings surprise is referred to as the post-earnings announcement drift, or simply “PEAD.” It is typically positive for a beat and negative for a miss. What’s notable about the PEAD is that it often extends for a period after the earnings announcement. Yes, there is an immediate reaction but there is also a lagged effect. This lagged effect reflects slowness on the part of investors (institutional and individual) in absorbing the new information and reassessing their outlook for the stock.

The magnitude of the surprise also plays a role. Exceeding expectations by a penny or two counts as a beat, but it is not as much of a surprise as being well above expectations. When companies issue earnings that are big (positive or negative) surprises, they tend to have a bigger reaction. This is particularly the case if the surprise was above (below) the most optimistic (pessimistic) analyst’s forecast.

Surprises and guidance are two different things. A company could top analyst expectations but then lower its own expectations (called guidance) for the remainder of the year. It’s preferable to have a company beat the consensus estimate and also raise its guidance above what analysts have been expecting. Similarly, you want to be cautious if a company both misses the consensus estimate and also lowers its guidance.

There are two AAII stock screens focused on earnings estimate revisions: the Estimated Revisions Up 5% screen and the Estimate Revisions Top 30 Up screen. They are among our best-performing screens since inception, with annualized price gains of 21.3% and 21.0%, respectively (based on monthly reconstituting of the passing companies).

Because there is a calendar-based cyclicality to earnings estimate revisions, stocks fall off the passing companies list for each of these screens simply because analysts didn’t make any significant changes to their estimates between earnings announcements. If you wish to avoid high levels of turnover, it can be worthwhile to hold onto a stock dropped from either screen if the only change is a lack of new revisions by analysts.

One thing I like about earnings estimate revisions is that they can be layered onto many other strategies. Growth investors can use them to ensure the companies they invest in are expected to continue to grow at a stronger-than-anticipated pace. Value investors can use them to identify bargain stocks with a catalyst to rise in price. Chartists can use earnings estimate revisions to determine if there is underlying support for the expected price trend.

Regarding the revisions that analysts are currently making, Refinitiv’s consensus estimate now calls for S&P 500 earnings to rise 1.5% this year. This is up from 1.3% growth projected on July 1, signaling positive aggregate revisions. Analysts have also raised their 2024 forecasts to reflect 12.1% growth, up from 11.7% on July 1.