Quant Concepts: Earnings Surprises

CPMS's Phil Dabo finds a strategy with very strong performance over time that can also add diversification to portfolios

Phil Dabo 4 June, 2021 | 2:38AM
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Phil Dabo: Welcome to Quant Concepts' working from home edition. Earnings can be an important element to look at because it can provide insight into how the company is performing. Equally as important, we can take a look at earnings surprises to see if these companies are performing better than analysts expect them to.

Today, let's take a look at a strategy that focuses on companies that have positive earnings revisions and have beaten analyst expectations.

Now, let's take a look at the strategy. We are going to start by selecting our universe of stocks, which includes all 700 stocks in our Canadian database. We are going to rank our stocks from 1 to 700 according to three key factors. The first factor is our quarterly earnings surprise to measure the company's reported earnings in relation to analyst expectations. We would like to see companies consistently beat those analyst expectations. The next factor is our earnings variability to measure the dispersion of earnings per share over time. Ideally, we would like to see companies that report great earnings numbers that don't have a high level of variation. The third factor is our three-month earnings revision. We'd like to find companies that analysts are looking at favorably, which translates into positive earnings revisions.

Now, let's take a look at our buy rules. We are only going to buy stocks that are ranked in the top 20th percentile of our list. And the next factor is very interesting. We would like to buy companies that have positive quarterly earnings and annual earnings momentum. Here, it's okay for either the quarterly or annual earnings momentum to be negative, but they can't be negative at the same time. In an attempt to reduce market risk, we have limited to buying stocks that have a beta of greater than 1.2. Our last buy rule is the deviation around the three-year earnings per share. This is another metric to reduce the volatility around reported earnings per share based on three years of data.

Now, let's take a look at our sell rules. We are going to sell stocks if they fall out of the top 50th percentile of our list. We are also going to sell stocks if their quarterly earnings momentum and annual earnings momentum are both negative at the same time. And our last sell rule has to do with market risk, and we are going to sell stocks if their beta becomes greater than 1.2.

Now, let's take a look at performance. The benchmark that we use is the S&P/TSX Total Return Index, and we tested this strategy from January 2006 to April 2021. Over this time period, this strategy has generated a very strong 20.3% return, which is 14.1% higher than the benchmark, but it also comes with a slightly higher annualized turnover of 76%.

When looking at performance, we can see that this strategy has outperformed the benchmark over every significant time period, but it's also done so with higher price risk as you can see by the standard deviation. Even though it has a higher standard deviation, it still has superior risk-adjusted returns as you can see by the Sharpe Ratio and slightly lower market risk as you can see by beta.

When looking at this chart, you can see very strong performance over time. And when looking at the up and downside capture ratios, we can see that this is a strategy that has performed well in down markets, but it's still participated very nicely in up markets. Overall, we can see that this is a strategy that has performed well throughout different market cycles.

This is a great strategy to consider if you are interested in companies that have beaten analyst expectations and if you are interested in companies that have positive earnings revisions from analysts. Although this strategy may seem a bit more risky, it has still beaten the benchmark 13 out of the past 15 calendar years. You can find the buy list along with the transcript of this video.

From Morningstar, I'm Phil Dabo.

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For a larger image of the buy list, click here.

 

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Phil Dabo  Phil Dabo is Director, CPMS Sales

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