Because both positive and negative earnings surprises (i.e., reported earnings above or below analyst expectations) can have long-term persistent effects, tracking analyst revisions is a strategy rewarding investment. AAII has created four screens that look for earnings estimate revisions: one that looks for upward revisions to annual earnings estimates; the one that filters companies with downward revisions; one that selects companies whose annual profits have increased by at least 5% over the past month; and, finally, a model that selects companies whose estimated annual profits have declined by at least 5% over the past month. AAII Pro Stock Investor contains consensus earnings estimates for LSEG I/B/E/S and is used to perform our screens.
In this article, I discuss the strategy that focuses on companies whose annual profits have increased by at least 5% over the past month. AAII Estimate revisions up 5% The selection model shows an average annual gain since its creation (1998) of 20.6%, compared to 5.8% for the S&P 500 index over the same period.
Current Trends in Earnings Estimate Revisions
S&P 500 companies saw their profits and revenues grow at a slower pace in 2023, with annual profits expected up 2.4% and annual revenues expected up 2.0% according to LSEG I/ B/E/S. Analysts expect double-digit earnings growth of 12.1% for the S&P 500 in 2024. The energy sector weighs on revenues and growth rates; excluding the energy sector, the expected profit growth rate for the full year is closer to 5.7% and the expected revenue growth rate is 4.7%.
The impact of surprises on profits
Expectations play a key role in determining whether a stock’s price rises or falls when actual earnings are released. Investors are quickly discovering that the market is forward-looking. Securities are priced based on expectations, and prices fluctuate as these expectations change or prove incorrect.
There are several services that track and analyze expected profit 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.
When using earnings estimates, the first rule to keep in mind is that the current price generally reflects the consensus earnings estimate. It is common to see price declines for stocks that have increased earnings from the previous reporting period because, in many cases, even though actual earnings represent an increase, the increase is not as large than what the market had predicted. Earnings surprises occur when a company reports actual earnings that differ from consensus earnings estimates.
Most companies announce their results about a month after the end of the quarter. During earnings reporting season, business news channels and financial websites provide daily reports on earnings announcements. Companies with significant earnings surprises are often highlighted.
Positive earnings surprises occur when actual reported earnings are significantly higher than expected earnings per share. Negative earnings surprises occur when reported earnings per share are significantly lower than expected. The stock prices of companies with significant positive earnings surprises perform above average, while those with negative surprises perform below average.
Stock price changes resulting from an earnings surprise may be felt immediately, but surprises can have a long-term effect. Studies indicate that the effect can persist for up to a year after the announcement. This means it doesn’t make sense to buy a stock after the initial price decline following a negative earnings surprise. There’s a good chance the stock will continue to underperform the market for some time. It also indicates that it may not be too late to buy shares in an attractive company after releasing a better-than-expected earnings report.
It’s no surprise that larger companies tend to adapt more quickly to surprises than smaller ones. Larger companies are followed by more analysts and portfolio managers, who tend to act quickly. Companies with strong quarterly earnings also often have earnings surprises in subsequent quarters. When a company has a surprise, it’s often a sign that similar surprises will follow.
Since positive and negative earnings surprises have persistent long-term effects, a rewarding investment strategy is one that avoids stocks that you expect will have negative earnings surprises or that have had negative earnings surprises in matter of profits. Picking positive earnings surprise stocks before and even after the earnings release can be just as profitable. Even a strategy of simply selling after negative earnings surprises and buying after positive earnings surprises probably has merit.
Stocks with upward revisions could outperform
Analyst revisions to earnings estimates lead to price adjustments similar to earnings surprises. When earnings estimates are revised upwards significantly (5% or more), stocks tend to perform above average. Downwardly revised company stock prices perform below average after adjustment.
Changes in estimates reflect changes in expectations for future performance. Maybe the economic outlook is better than expected, or maybe a new product is selling better than expected.
Revisions are often a precursor to earnings surprises. As the reference period approaches, estimates normally converge toward the consensus. A flurry of revisions heading into the reporting period may indicate that analysts have missed the mark and are scrambling to improve their estimates.
Companies like to report positive earnings surprises, so it’s not surprising that many companies try to “manage” estimates slightly lower to create a positive surprise. Studies show that on average, there are more positive quarterly surprises than negative surprises. Interestingly, estimates for the fiscal year do not tend to show the same positive surprise bias.
Controlling earnings estimate revisions up 5%
AAII’s first filter eliminates companies with fewer than five estimates for the current fiscal year. This filter helps ensure that revisions truly reflect a change in the general consensus, not just a change made by one or two analysts. However, requiring at least five analysts to issue earnings estimates for a stock will eliminate most smaller-cap stocks.
The number of estimates for each company is provided to help gauge interest in the company and the relevance of the overall estimates. The larger the company, the more analysts will follow it. The number of upward revisions indicates how many analysts have revised their estimates upward over the past month. Compared to the number of analysts making estimates, this confirms the importance of the percentage change in estimates. You may place more confidence in a revision if a significant percentage of the analysts who follow a company have revised their estimates.
The next filter requires the company to have an upward change over the past month in its consensus estimates for the current fiscal year (Y0) and next fiscal year (Y1). We also check that analysts haven’t cut estimates for the current or next fiscal year in the last month. Naturally, we also look for companies whose estimated profits for the current and next financial year have increased by at least 5% over the past month.
Shifting Expectations Boost Stock Prices
Revenue estimates are important. It is a numerical view of expectations, and changing expectations determine stock prices. If you invest in individual stocks, there are a few things to keep in mind about profit estimates:
- Know the consensus earnings forecast for a stock you own or are interested in.
- Be aware that the stock price already reflects the consensus on future earnings. Be aware that if a stock is highly touted, the basis for the recommendation should be an analyst earnings forecast that is significantly higher than the prevailing view.
- Before investing, inquire and carefully evaluate the basis for an earnings forecast that deviates materially from consensus.
- Significant earnings surprises, positive or negative, likely have a long-term effect on a stock’s price, with analysts revising their long-term earnings forecasts accordingly.
Stocks Passing the Estimate Revisions Up 5% Screen (Ranked by Current Year Revisions Made Last Month)
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Stocks meeting the criteria of the approach do not constitute a “recommended” or “buy” list. It is important to do your due diligence.
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