AMZN
Efficient market proponents like to say that the market does a good job of pricing itself and that asset prices reflect all available information. Stock prices generally reflect the market’s consensus of a full array of company, industry, regulatory and economic forces in play at any time. However, the market is also in a constant state of flux and may not always react rationally and instantly to new information. Benjamin Graham understood the challenge investors face and put forth that for an investor to beat the market, they first must have a sound theory, then have opinions and projections that are not only correct but also different from those of the market.
Stock prices are established through expectations and adjust as those expectations change or are proven wrong. A slight change in projections can have a major impact on stock prices, especially if the multiple or price-earnings (P/E) ratio investors are willing to pay for a given level of earnings also expands or contracts. Stocks with high price-earnings ratios not only have high expectations, they also possess a higher anticipated certainty of realizing their growth. Lower multiples reflect lower perceived prospects as well as greater risk and uncertainty of achieving results.
Consensus estimates are the average of the analyst estimated earnings and sales levels made by analysts who are following specific companies. Widely followed firms such as Amazon.com Inc. (AMZN) have over 40 analysts providing estimates, while smaller firms have just a few analysts following them. Over 460 companies have just one analyst projection. Just over 3,750 companies currently have earnings estimates from the universe of 4,641 exchange-listed companies tracked by I/B/E/S, a reporting service used by AAII.
When using earnings estimates, the first rule to consider is that the current price generally already reflects the consensus estimate. There is nothing to gain by simply looking for companies with high levels of expected earnings growth. Studies show that over the long run, stocks with high expected earnings growth tend to underperform stocks with lower growth projections. It is difficult to continually meet and exceed high expectations over an extended period—commonly referred to as reversion to the mean. The most profitable earnings estimate strategies focus on surprises and revisions.
Stock prices of firms that significantly exceed analyst expectations (positive earnings surprise) tend to outperform the market, while those with negative surprises tend to underperform.
The impact of the earnings surprise is longer lasting than most would think. The greatest effect of the surprise can be seen immediately, but the impact of the surprise can be felt for as long as a year. The impact tends to be longer lasting for negative earnings surprises. It simply takes time for the market to recognize that a fundamental shift is taking place. This means that it does not generally make sense to be a bargain hunter and buy a stock after the initial price decline on a negative earnings surprise. There is a good chance the stock will continue to underperform the market for some time. Separately, it may not be too late to buy into an attractive stock after a better-than-expected earnings report is released, provided the fundamentals are still valid.
Not surprisingly, large firms tend to adjust to surprises faster than small firms. Larger firms are followed by more investors, analysts and portfolio managers acting on the information more quickly and thoroughly.
Firms with a significant quarterly earnings surprise also often have earnings surprises in subsequent quarters. This is sometimes referred to as the “cockroach effect”—like cockroaches, you rarely see just one earnings surprise.
Studies of earnings estimates by David Dreman found that stocks with lower valuations reacted more strongly to positive earnings surprises than did highly valued stocks. A positive earnings surprise for stocks with a high valuation (as measured by factors such as price-earnings ratios) is not truly a surprise. It is a reinforcing event that does not change the perception of a company. However, positive earnings surprises for out-of-favor stocks are event triggers that initiate a perceptual change among investors. Dreman’s work notes that the opposite happens with negative surprises. Out-of-favor stocks often barely flinch, while highly favored stocks generally have significant declines after a negative surprise.
The chance of an earnings surprise is more significant if the range of estimates for a company is wide; however, the price move can be more dramatic if an earnings surprise occurs for a firm with a very tight range of estimates and the actual earnings are well outside that consensus.
Changes in estimates reflect changes in analyst expectations of future performance and lead to price adjustments similar to 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-market performance.
Changes in analyst estimates are more meaningful when individual estimates move away from the average, rather than toward the consensus.
A+ Investor subscribers have exclusive access to Stock Grades for over 6,000 stocks for factors of value, growth, momentum, quality and estimate revisions. The estimate revisions grade ranks companies by the strength of their recent quarterly earnings surprises and earnings revisions for the upcoming fiscal quarter and year.
The Stocks page of AAII.com notes if any stocks have consistently high or low grades across the many factors and separately reveals significant changes in their grades:
The “My Stocks” tab of the A+ Stock Grades section shows you the factor grades for all of the stocks you have entered into portfolios you’ve created using the My Portfolio tool:
Clicking the “See All” link will give you the factor grades for all the stocks you hold or track. Seeing these grades can offer confirmation of why you are holding or tracking these stocks or provide an indication that something is changing that requires additional analysis.
The My Upgraded/Downgraded Stocks tab of the A+ Stock Upgrades & Downgrades section lists those stocks you hold or track with My Portfolio that have seen two or more factor grade changes in the same direction over the last trading day:
Once again, clicking the “See All” link will show you all of your stocks that have seen at least two factor grade changes in the same direction over the last trading day.
Earnings estimates are an important element to consider as investors look for stock ideas and manage their holdings.
Using the new A+ Stock Grades Screener, you can isolate those companies that grade highly based on earnings estimates (along with growth, value, momentum and quality).
The A+ Stock Grades Screener allows you to filter for stocks with specific factor grades. As of the close on February 20, 2020, there were 243 stocks out of the universe of 6,089 companies with an estimate revisions grade of “A”:
This is still a large universe of companies to sift through, but applying filters for above-average value (B or better) and average levels of growth, momentum and quality (C or better for all three factors) narrows the number of companies down to 32:
This table is sorted in descending order by momentum.
To dig deeper into the Estimate Revisions Grade for an individual stock, we clicked on Sleep Number Corp. (SNBR) from the table list to get to its Stock Evaluator page. From there, clicking on the Grades tab takes you to a detailed explanation of each of the five factor grades. For this example, we focus on Sleep Number’s Estimate Revisions Grade:
Sleep Number has an overall Estimate Revisions Grade of “A.” This grade is arrived at by using four different pieces of data:
To say that a company missed or exceeded their quarterly consensus estimate does not necessarily capture the real significance of such an event. There are several ways of measuring the significance of an earnings surprise. One method of measuring the magnitude or significance of earnings surprises is with the standardized unexpected earnings (SUE) score. SUE measures the earnings surprise in terms of its number of standard deviations above or below the consensus earnings estimate. An earnings surprise is considered more significant the farther it is outside the statistical range of estimates expected at the time of the announcement. Assuming a normal distribution of earnings estimates, 68.3% of actual earnings will be within one standard deviation of the consensus estimate, 95.4% will be within two standard deviations, and 99.7% will be within three standard deviations. The absolute value of SUE measures the degree of unexpected earnings. There is no earnings surprise when the SUE score equals zero; the actual earnings per share is in line with the consensus earnings estimate.
The standard deviation of Sleep Number’s estimates for its quarter ended December 31, 2019, was $0.46. Given this, along with the difference between Sleep Number’s reported earnings for the quarter ($0.82) and the consensus estimate ($0.747) of $0.073, we arrive at a statistically significant SUE score of 1.6 for the latest quarter.
The consensus earnings estimate for Sleep Number’s current fiscal year ending December 31, 2020, stands at $3.098. A month ago, it was $2.944 and three months ago it was $2.946. Using these numbers, we arrive at the percentage change over both the last month and the previous three months of 5.2%.
The “raw” values of the four metrics used for Estimate Revisions Grade are then converted to percentile ranks, which compares them against all of the stocks in the universe. Sleep Number’s SUE score for the latest quarter of 1.6 ranks in the 71st percentile among the 6,000 or so stocks in the universe. The percentile ranks for the four underlying metrics are then averaged; for Sleep Number, that translates into an estimate revisions score of 81, which places it in the “A” or “very positive” range.
While investing in companies seeing significant upward earnings revisions has been shown to generate promising results over the long term, it is important to take into consideration elements of financial strength, quality or price momentum. As an A+ Investor, not only can you evaluate the estimate revisions of individual stocks, you can use the Stock Grades Screener to isolate those companies with high estimate revisions scores along with elements of growth, momentum, quality and value.
If you have any questions or comments about this week’s topic, or have anything to say about A+ Investor, reach out to us directly at aplus@aaii.com.
