Quant Concepts: A Portfolio for U.S. Earnings Surprises

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Phil Dabo: Welcome to Quant Concepts. Last week we looked at Canadian companies that had beaten analyst expectations. So I thought that it would make sense to look at U.S. companies this week that are beating expectations. We're at the tail end of earnings season and analysts have had the time to incorporate the quarterly results into their financial projections. In today's strategy, we're going to look for companies that have positive earnings per share momentum, positive analyst revisions, and are beating those analyst expectations on a quarterly basis. As always, let's start by ranking our universe of stocks, which includes everything on the S&P 500. Next, we're going to rank our stocks according to four key factors.

The first factor is the quarterly earnings surprise because we'd like to see companies that have beaten analyst expectations. The next factor is a three-month earnings revision because we'd like to find companies that analysts have a positive expectation for. The next factor is the quarterly earnings momentum because we'd like to find companies that are growing that bottom line. And our last factor is the earnings variability around five year earnings per share so that we focus on companies that are more consistent when reporting that bottom line number.

Now that we have our stocks ranked from one to 500, we're going to go through our screening process, starting with our buy rules. We're only going to buy stocks that are ranked in the top 30th percentile of our list. And we're only going to buy stocks that are ranked in the top third, based on the three-month earnings revision. We want to reduce the amount of volatility in the portfolio by excluding stocks that have a very high standard deviation. So we've excluded stocks that are in the bottom third based on the 180 day standard deviation. Since our model relies on analyst forecasts, we've placed a minimum of five on the number of analysts following the stock. We've used the Morningstar quantitative financial health score to assess if a company is in good financial health and determine the likelihood that they'll fall into financial distress. Here we want companies to be ranked in the top third. Our last buy rule is the price change to 12 month high because we found that certain companies trading close to their previous 12 month high have tended to perform well.

Now let's take a look at our sell rules which are a bit different today because we're not going to sell stocks based on the overall ranking. As you can see at the top of the screen here. We're okay with all stocks in the top 100th percentile. However, we're going to sell stocks if their earnings revision becomes extremely negative and falls to the bottom of our list. And we're also going to sell stocks if they become too volatile and fall to the bottom third of our list based on the 180-day standard deviation. Our last sell rule will eliminate stocks if their financial health deteriorates and falls to the bottom third of our list based on the price change to 12 month high.

Now let's take a look at performance. The benchmark that we used is the S&P 500 Total Return Index. And we tested this strategy from January 2006 to October 2021. Over this time period, the strategy generated a very strong 14.6% return, which is 3.9% higher than the benchmark with only a 45% annualized turnover. We can see by looking at the annualized returns, that this is a strategy that has performed well over longer periods of time. And I think it's important to note that this doesn't tell the overall picture. The strategy has outperformed the benchmark over every calendar year except for one over the past 10 years. And it's only had one negative calendar year.

When looking at the standard deviation, we can see that the strategy has lower price risk compared to the benchmark, which contributes very nicely to higher risk-adjusted returns when looking at the Sharpe ratio. It's no surprise here that the strategy also has lower market risk when looking at beta. When looking at this performance chart, we can see that the strategy outperforms very nicely over time. And when looking at the up and downside capture ratios, we can see that this is a strategy that has particularly outperformed the benchmark in down markets, which has contributed very nicely to an overall market capture ratio, showing that this is a strategy that has performed well throughout different market cycles.

This is a great strategy to consider if you're interested in companies that have positive earnings momentum tied with positive analyst expectations and the ability to beat those expectations on a quarterly basis. As I mentioned before, the strategy has performed very well over the past 10 years and has rarely ever lost to the benchmark. You can find the buy list along with a transcript of this video.

From Morningstar, I'm Phil Dabo.

Find the buy list here.