If there’s one truth in stock analysis, it’s that earnings drive stock prices. Over the long-term, earnings reflect the essential health of a company. If a business cannot eventually book income, it will bankrupt itself. And companies that continue to turn in earnings growth year after year will see their stock prices rise. As you can see by this graph, earnings have a great influence on stock prices.
Of course, earnings are not the only factor that affects the movement of stocks. Especially in the short-term, investors’ attitudes, sentiments and expectations are the real key to pushing stock prices higher. You only have to look back at the tech boom in the late 1990s to understand that investors—hyped up by the tech industry and Wall Street—bid prices of technology stocks through the stratosphere, even when they had zero earnings and no hope of earnings anytime in the near future.
But usually, short-term investor sentiment is dictated by Wall Street analysts. Investors are often influenced by
• Initiation of coverage by analysts
• Changes in insider and institutional trading
• Stock splits and buybacks
But most of all, investors love positive earnings surprises.
Double-Digit Earnings Surprises
Most companies trading today have at least some analyst coverage. And those analysts issue forecasts of expected earnings for the next few quarters and years. Once earnings are reported, the media jumps in, comparing actual earnings with forecasted results.
This morning, I reviewed earnings reports from the last few days for positive surprises, and I found these five companies with some pretty impressive earnings surprises:
Alcoa’s earnings improved due to the growth of the aluminum market in the aerospace and automotive industries, as well as a healthy cost-cutting program.
VOXX also benefited from the growth in the auto industry.
Apollo Education had great international expansion, is transforming its University of Phoenix division, and is on the verge of a merger.
GMS is seeing growth from the rise in wallboard sales due to more activity in home repairs and increasing home sales.
AngioDynamics saw strong results from its expansion in the medical device industry.
Following the earnings announcements, AA, GMS and ANGO all saw their stocks rise. APOL shares had already increased fairly significantly after its merger was announced. And since VOXX is still in negative earnings mode—although improving—investors didn’t give it much love after its earnings report.
These companies illustrate how much emphasis investors place on earnings surprises. They often react very quickly to both positive and negative surprises, buying or selling shares accordingly.
It’s common knowledge that—for the most part—because companies realize the weight that investors place on earnings surprises—they work very diligently with their analysts to come up with realistic estimates. And then they try very hard to surpass those, so their stocks will benefit. And most of them do.
According to Factset, since 2014, on average, 68.5% of companies in the S&P 500 have beaten their quarterly EPS estimates.
And in the current earnings season, 14 of the 23 companies in the S&P 500 that have reported Q2 2016 earnings to date have reported earnings above the mean analyst estimate.
Here’s what Investopedia noted in a recent report studying stocks in the S&P 1500 Composite since 2011: “Positive earnings surprises are followed by continued and steady buying of shares over the following month. On average, after gaining 1.6% in the day immediately following earnings, stocks reporting positive surprises show a 2% post-earnings gain after 15 days and a 2.6% gain after 30 days.”
How does an Investor Profit from Earnings Forecasts?
While it sounds like you could make bets on which companies would surpass their earnings forecasts, buy shares before the announcement and sell them immediately after, it’s not that easy.
First of all, as AAII noted in a recent blog, contrarian investor David Dreman’s study from 1973 to 2010 indicated that analysts’ forecasts were off by about 40% annually.
In a more recent study, CXO Advisory Group found that since the fourth quarter of 1988, the average quarterly analyst forecast error is -2.1% and the standard deviation of forecast errors is 17.7% (pretty large).
Dreman went on to say that investors shouldn’t set much store in the actual forecast, but try to profit from the errors. To do this, buy out-of-favor stocks with low expectations. For example, Dreman says that stocks with low P/Es “reacted more strongly to positive earnings surprises than did high price-earnings stocks.” Those stocks rose 6.7% higher in the year following a positive earnings surprise, compared to a 0.6% for stocks with high P/Es.
And for negative earnings surprises, low P/E stocks actually increased 1.2% in the year following the surprise, compared to a decline of 7.4% for their higher P/E cousins.
That certainly runs against common perceptions, doesn’t it?
Low Expectations Could Add Up to High Gains
Let’s give it a try and apply this strategy to the five companies listed above. Four out of the five (the exception being GMS) have negative P/Es. GMS’ P/E ratio is 65.89, so we we’ll eliminate GMS and focus on the remaining four stocks.
Average Analyst Ratings:
In analyst-speak, 1 is a Strong Buy and 5 is a Sell. Consequently, while these stocks are all in the buy/hold range, none of the companies would be considered ‘hot’ by Wall Street standards.
Now, let’s take a look and see if there’s much insider or institutional trading going on in the shares:
AA: Insiders have recently purchased 0.9% of AA’s shares, but institutions have sold 8.57%.
VOXX: Insiders have recently sold 2.10% of VOXX’s shares; institutional holdings have declined by 21.8%
APOL: Insiders have decreased their holdings of AA’s shares by 0.10%; institutional holdings have dropped by 26.26%
ANGO: Insiders have been trading the stock recently, but institutions have lowered their holdings of the stock by 13.28%.
Again, for the most part, these stocks aren’t getting much positive attention from insiders or Wall Street. And yet, they all had significant earnings surprises. Certainly, more investigation is called for. But if you are feeling ‘contrarian,’ you may want to explore the prospects of these companies a bit more to determine if they may have a place in your portfolio.
Editor, Wall Street’s Best Investments and Wall Street’s Best Dividend Stocks