U.S. earnings beaters are gold for your portfolio

By Michael Pe, CFA on October 29, 2017
Estimated reading time: 3 minutes

It's a simple strategy: buy stocks that beat their earnings estimates. If you followed this approach since 1999 you would have outperformed the market by 8.4% per year

Wall Street — (Cultura Travel/WALTER ZERLA)

With the U.S. earnings season in full force, many investors are paying close attention to whether stocks are beating or missing earnings estimates. As you may know, stocks can soar immediately after they report an earnings number that is significantly higher than expectations. To experience such gain in your portfolio, you would need to own the stock before it reports its earnings. However, most investors do not have the consistent forecasting skill to predict which stocks will exceed earnings consistently. If they do, it is either through luck or a magic crystal ball. Conversely, you can purchase the stock after the earnings report, at which time we already know it has surpassed estimates. The question is, do these “estimate beaters” continue to climb long after its initial spike?

The test

To test if beating expectations can have a longer-term return effect, I used Morningstar CPMS to create a strategy that will invest in stocks that have exceeded analyst earnings consensus outlook by the greatest amount. This is calculated using a Standard Unexpected Earnings formula:

Standard Unexpected Earnings = (Actual Earnings – Consensus Earnings Estimate) / Standard Deviation of Earnings Estimates

Also, the strategy only considers stocks that have reported earnings in the last 30 days. No market cap restriction was used but only stocks on the S&P 500 were considered.

The results

I back-tested the strategy from October 1999 to September 2017, using an initial investment of $10,000. During this process a maximum of 10 stocks were purchased and equally weighted. Quarterly, at the end of each January, April, July and October (which are the months in which most of the S&P 500 stocks report their earnings), the portfolio would be replaced with the stocks that had the greatest positive earnings surprise. The strategy produced an annualized total return of 13.9% over the period while the S&P 500 total return index advanced 5.5%, resulting in an outperformance of 8.4%. The initial investment of $10,000 grew to $102,290 over the 17 year time frame. From these results, it seems that stocks passing expectations can provide longer term gains for months even after the initial spikes, which would usually only benefit the fortunate investors who owned the stocks beforehand. You can find a list of the 10 stocks currently in this strategy below.

Caution

While there seems to be an outperformance effect for estimate beaters, this strategy does underperform at times, and by a significant amount. In 2013 when the S&P 500 had a whopping return of 27.2%, this strategy delivered 12.6%, an underperformance of 14.6%. Although, the strategy did climb 23% the following year vs. the index’s 17.3% return. Furthermore, the back-test is limited to transact at month-end. This means there is more of a time delay effect for stocks which report earlier in the month. It would be a better test to purchase stocks as soon as possible after the earnings report. As always, quantitative strategies like this one are only based on the specific mentioned criteria. No consideration is placed on any of the stocks’ operations, industry outlook or management. You may or may not want to take those items into account when analyzing stocks to invest in.

The beats can fly

Estimate beaters can have soaring returns immediately after they report earnings. However, to capitalize on those returns, you would need to own the stock beforehand either through luck, or a unique and rare earnings forecasting skill. Everyday investors shouldn’t count on either. Instead, it is still possible to capture tailwind gains on these stocks after they report. Just be wary of the turbulence.

Rank	Symbol	Company	Standard Unexpected Earnings	Market Cap ($mil)
1	EW	Edwards Lifesciences	18.2	$23,082
2	AMT	American Tower Corp	12.8	$58,660
3	EA	Electronic Arts Inc	12.5	$36,448
4	MRK	Merck & Co Inc	11.7	$174,632
5	MHK	Mohawk Industries Inc	11.0	$18,399
6	RTN	Raytheon Co	9.6	$54,155
7	APH	Amphenol Corporation	9.0	$25,853
8	ALGN	Align Technology Inc	8.7	$14,930
9	HSY	Hershey Company	8.6	$23,193
10	ZION	Zions Bancorporation	8.1	$9,538

Michael Pe, CFA is an Institutional Product Specialist at Morningstar Research Inc.

About Michael Pe, CFA

As a CFA charterholder with over a decade of experience in the financial industry, Michael writes about the real estate market, personal finance and investing.