AAII Stock Ideas: Upward Earnings Estimate Revisions Screening Strategy

This past week was the kickoff of Q4 and needless to say there were some major surprises that triggered six consecutive days of triple-digit losses.  With that in mind, the AAII published a very insightful article this week about how to turn earnings estimate revisions to one's favor. If ever this this type of strategy will be useful, it is now.  Enjoy the rest of the weekend.  

AAII Stock Ideas

Upward Earnings Estimate Revisions Screening Strategy

Dear Fellow Investor,    In these volatile markets, we wanted to make sure our valued members get access to the best information possible to help you navigate the uncertainty. This is why you may have noticed the recent enhancements to our Stock Ideas Update email.  Each week, we give you education and stock ideas that are relevant to today’s market. Markets like these expose bargains, so we want to highlight a few ideas that can help you replenish your portfolio through sound strategies with good long-term performance.  If you find this information valuable and want an edge throughout this market volatility, you can access robust stock screens and evaluations through A+ Investor, a suite of rigorous investment tools that includes diversification analysis, stock evaluators and more than 50 stock screens updated every day.

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 investment strategy. AAII has created four screens that look for earnings 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 I/B/E/S and is used to perform our screens.   This week we discuss the strategy that focuses on firms that have had at least a 5% increase in annual earnings estimates over the last month. AAII’s Estimate Revisions Up 5% screening model has shown incredible long-term performance, with an average annual gain since 1998 of 22.9%, versus 6.6% for the S&P 500 index over the same period.   Current Trends in Earnings Estimate Revisions   The year 2021 saw record high earnings growth for the S&P 500 of 45.1%, but earnings growth in 2022 is expected to massively taper off for corporations in comparison. According to FactSet, analysts are expecting single-digit earnings growth for the S&P 500 in 2022 of 9.2%. Despite the large reduction in estimated earnings growth rates, the projection is still above the trailing 10-year average earnings growth rate of 5.0%. FactSet projects that 10 of the 11 S&P sectors are projected to have year-over-year growth in earnings, led by industrials, consumer discretionary and energy sectors.   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 change as these expectations change or are proven incorrect.   There are several services that track and analyze expected earnings estimates. Services such as Refinitiv 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 the forecasted earnings per share. Negative earnings surprises occur when reported earnings per share are significantly below the 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 a year after the announcement. This means that it does not make sense to buy a stock after the initial price decline of 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.   Not surprisingly, 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 often is a sign that other similar surprises will follow.   Since both positive and negative earnings surprises have lingering long-term effects, a rewarding investment 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 very small-capitalization 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 is a confirmation of 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 have revised their estimates.   The next filter requires that the firm have 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 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. Ask for and carefully evaluate the foundation of an earnings forecast that deviates substantially from the consensus before investing. 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.