by Matthew Weinschenk, Senior Analyst
Thursday, June 11, 2009: Issue #1016
Editor’s Note: In a recent article, Matt Weinschenk showed his readers an easy way to sort through the earnings reports that have been coming out. We’re republishing it here because following earnings is a key concept in our Investment U course and Matt gives us his insight on taking advantage of them…
Investors eyed this batch of quarterly earnings with more anticipation and scrutiny than any in recent memory. And who can blame them, really?
With a recession in full swing, companies lining up for government bailouts and economists taking to the streets of New York with “The End is Near” sandwich boards, nobody knew what to expect.
Earnings reports, however, tell the real, unabridged story of what’s happening with America’s businesses…
So now that most of the numbers are out, what did we learn? And more importantly, how can we profit from it moving forward?
It depends on how you slice the data…
Who’s Really Beating Earnings Report Estimates?
Had we limited our earnings report focus to the early-reporting S&P 500 companies, our level of pessimism may have seemed overdone. After 108 companies reported, total earnings beat estimates by 20%. But don’t celebrate just yet.
After 455 companies in the S&P 500 reported, it wasn’t pretty. According to numbers provided by Standard and Poor’s, total earnings were 25% below estimates. And only 37% of companies beat Wall Street’s expectations.
Now, don’t forget, we’re not talking about growing earnings over last quarter or last year – that wasn’t even considered as a possibility. We’re talking about beating the watered-down earnings report estimates of analysts who had taken into account all of the unfavorable economic news.
Sounds bad, eh? Not necessarily.
You see, if we broaden our scope to include almost 2,000 companies, as Bespoke Investment Group did, we get a much more optimistic view.
Only 37% of the S&P 500 managed to trump analyst expectations, however, 62% of the companies in Bespoke’s universe did beat estimates (commonly called the “beat rate”). That’s better than the average beat rate since 1998 (61%) and a big jump from last quarter (55%).
With small cap investing, we’re much more interested in the overall beat rate than the S&P beat rate, anyway. Remember, the S&P 500 tracks the country’s 500 largest stocks.
Of course, the markets get to cast the final vote on earnings. When it comes to small caps – despite a financial crisis and a recession – this earnings season has, so far, seen a 40.2% rally in the Russell 2000. If that’s not a sign of confidence, I don’t know what is.
So, there is hope for corporate earnings, particularly for small caps.
But how can we turn that into profits sooner rather than later? The same way we always can, with a phenomenon called the “post earnings announcement drift” (or PEAD).
The Post Earnings Announcement Drift (PEAD): An Anomaly With Regularity
After a stock announces an earnings report surprise, it has a strong and documented tendency to outperform the market over the next few quarters. Thus, it warrants our undivided investment attention.
And for the record, this effect isn’t in question. Respected researchers like S.P. Kothari of M.I.T. concluded that, “The PEAD anomaly poses a serious challenge to the efficient markets hypothesis. It has survived a battery of tests and many other attempts to explain it away.”
Most questions now revolve around why it happens and not if.
Since there are an infinite number of ways to quantify the effect of PEAD, there’s no single number to explain exactly how much outperformance to expect. One summarization, by Jack Hough of The Wall Street Journal, claims, “The top 20% in terms of upside surprises beat the broad market by three percentage points over the next six months.”
That might not seem like a lot, but it adds up.
You can keep track of earnings report surprises easily by navigating on the web to http://biz.yahoo.com/r/ (just click on “Surprises”).
And if we get more stringent with our stock search, filtering for additional properties like:
- Revenue surprises,
- Low institutional ownership,
- Analyst experience,
- And arbitrage risk…
Then it stands to reason that we’ll witness an even higher PEAD and improved results.
So that’s exactly what we did…
Three Stocks That Stand Out This Earnings Report Season
Here are three stocks that stand out above the others from this earnings report season. And if history is any guide, they’ll likely outperform the rest of the market by a wide margin in the weeks and months ahead.
- Enbridge Inc. (NYSE: ENB). Consider this the Kinder Morgan of Canada. It operates a big network of pipelines and has raised stock dividends for 10 straight years.
- Hittite Microwave Corp (Nasdaq: HITT). A leader in the semiconductor industry that specializes in microwave communications, like RFID tags. It only beat estimates by 6%, but the industry suggests growth ahead.
- Millipore Corp (NYSE: MIL). A well-run supplier of medical and scientific technology and tools. Beating quarterly earnings estimates by 26% suggests that it’s a great long-term hold.
Exploiting market anomalies, especially ones that automatically isolate successful companies, is what smart investing is all about.