Quant Concepts: A Portfolio for Canadian Earnings Surprises

Learn how Phil Dabo assembles a group of Canadian stocks that consistently beat analyst expectations.

Phil Dabo 12 November, 2021 | 10:38AM
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Phil Dabo: Welcome to Quant Concepts. The beginning of earnings season starts right after the end of the quarter and it's very important for a number of reasons. This is the time for companies to report their quarterly results, which forms a basis for analysts to revise their expectations on stocks.

A lot of investment analysts will use the quarterly results to adjust their forecasts for the current year and this can have a significant impact on the price of the stock. For example, it's not uncommon for shares to jump by more than 20% after a company significantly beats analyst expectations.

Today, let's take a look at a strategy that focuses on quarterly earnings surprises, earnings momentum, and positive analyst revisions.

As always, we are going to start by selecting our universe of stocks, which includes all 700 companies in our Canadian database. Next, we are going to rank our stocks according to three key factors. The first factors are quarterly earnings surprise, because we'd like to find companies that are beating analyst expectations. Next is our variability of historic earnings per share to find companies that do not have a lot of volatility in their reported earnings. And lastly is our three-month earnings revision because we'd like to find companies that analysts have a positive outlook for.

Now that we have our stocks ranked from 1 to 700, we are going to go through our screening process, starting with our buy rules. We are only going to buy stocks that are ranked in the top 20th percentile of our list. Here, it's okay for our quarterly earnings momentum and our annual earnings momentum to be below 0, but they can't be below 0 at the same time. We placed a limit of 1.2 on beta to reduce the amount of market risk in the model. A beta of less than 1 means that the stock generally moves less than the overall market. Our last buy rule is the deviation around three-year earnings per share, which will also make sure that we eliminate companies with excessively volatile earnings. Here, we want companies to be ranked in the top third based on the deviation around three-year EPS.

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, and we are also going to sell stocks if they become too volatile and the beta goes above 1.2. Lastly, we are going to sell stocks if the quarterly earnings momentum and the annual earnings momentum are both below 0 at the same time.

Now, let's take a look at performance. The benchmark that we used is the S&P/TSX Total Return Index, and we tested the strategy from January 2006 to October 2021. Over this time period, the strategy generated a very strong 20% return, which is 13.3% higher than the benchmark, with a 74% annualized turnover. We can see by looking at the annualized returns that this is a strategy that has performed very well over longer periods of time, although it has had slightly higher price risk as you can see by the standard deviation, which is expected when we're looking at an earnings surprise strategy. Although it has had higher price risk, you can also see that it's had superior risk-adjusted returns by looking at the Sharpe Ratio. It's also had lower market risk as you can see by beta.

When looking at this chart, you can see very good outperformance by the strategy over time, which has contributed to very good alpha. And when looking at the up and downside capture ratios, we can see that this is a strategy that has performed very well in down markets while still participating in up markets, showing that overall, this is a strategy that has performed well over different market cycles.

This is a great strategy to consider if you are interested in companies that have positive earnings momentum, tied with positive analyst expectations and the ability to beat those expectations on a quarterly basis. This strategy has performed very well over the past 15 years, having only lost the index in 2009 when looking at calendar year returns. The buy list is diversified across sectors and includes companies of all sizes. You can find the buy list along with the transcript of this video.

From Morningstar, I'm Phil Dabo.

Find the buy list here.

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Phil Dabo  Phil Dabo is Director, CPMS Sales

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