Increase Odds of a Positive Surprise

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Posted: Jul 06, 2011 12:01 AM

By Dirk van Dijk, CFA 
 
Surprises are, by definition, unexpected. However, since we know that companies that report better-than-expected earnings tend to see their share prices rise after the announcement, and those that disappoint sink, it would be nice to be able to get in front of those that are likely to do better than expected and get out of the way of those which are going to disappoint.

Not easy to do, but there is a way to improve your odds. I like to look for the combination of three inter-related factors in trying to figure out who will post positive surprises, and who will disappoint.

Check the Recent History

I start with the fact that historically, companies that reported a positive surprise last time around are much more likely to do so in the next quarter than those that reported in line or disappointed. I thus required every firm in the screen below to have had a positive earnings surprise in its previous quarter.

However, positive earnings surprises are much more common than negative surprises. In the S&P 500, a “normal quarter” will have about three times as many firms reporting better-than-expected EPS than below-expected earnings.

Upward Revisions Are Key

The next thing I looked for was rising estimates for the quarter that is about to be reported. Often analysts will get a whiff that something good is going to happen, and will raise their estimates. However, they tend to be reluctant to go too far out on a limb, so if the consensus is looking for XYZ Corp. to earn $1.00 for the quarter, and the analyst gets information suggesting that the firm might be able to report $1.50, they do not raise their estimate all the way to $1.50. Instead they might raise it to say $1.25. That would make them the high estimate.

If the company does indeed report $1.50, they still look like a hero; if they report $1.00 they were not that far away from the herd, and thus retain some job security. Also, not all the analysts will get (or properly interpret) the information. If there are 10 analysts providing estimates for the quarter, one analyst raising his estimate from $1.00 to $1.25 would only raise the consensus (average) estimate by 2.5%. If another analyst follow suit the next month, that will raise the consensus by about another 2.5%.

This is one of the key reasons that an estimate in motion tends to stay in motion, and why it is so vital to pay attention to estimate revisions. I required that the consensus estimate for the completed, about to be released quarter have increased by at least 3% over the last four weeks. I did not insist on any particular level of expected earnings for the quarter, but the information, as well as what the company earned last year, is provided in the table below.

Keep in mind that low absolute levels tend to go hand in hand with big percentage changes. A move of a penny is a much bigger change if the base is $0.02 than if it is $1.00. The table below is sorted by the increase in the quarterly estimate.

Check the FY Estimate Momentum

I also wanted a sense that the estimate momentum for other periods was positive. The second quarter is, after all, part of the full fiscal year. Usually, increases for the quarter should be matched (at least in dollar, if not percentage, terms) by increases for the full fiscal year. There are exceptions to this -- for example, a big contract being booked in the second quarter rather than the third. But that sort of surprise is less likely to lead to big upward price moves.

My proxy for estimate momentum other than in the just-finished quarter is the Zacks Rank. I only considered those firms rated either #2 (Buy) or #1 (Strong Buy). Those are the strongest 20% of the firms out there on estimate momentum.

Creating a Workable List

By limiting the list to firms with Market Capitalizations of over $500 million, the list was whittled down to 31 firms. It is a remarkably diverse group. About half of the names are based outside the U.S. Nine of the 16 Zacks economic sectors are represented, but the biggest concentration is in Energy (8 firms) and Technology (7 firms).

Valuations also vary widely, with 7 firms having single-digit P/E ratios and seven having P/E ratios over 20, based on the consensus estimates for this year.

While there is no guarantee that these firms will all post better-than-expected earnings this quarter, history suggests that there odds of doing so are much better than average.

Company Ticker Completed Q Cons Est Q EPS Before NRI Last EPS Surprise % % Chng Curr Q Est - 4 wk % Chg Curr FY Est -1 wk % Chg Next FY Est - 4 wks Zacks Rank Market Cap ($ mil)
Gt Solar Intl SOLR $0.31 $0.11 20.59% 128.70% 0.00% 11.32% 1 $2,037
Merck Kgaa MKGAF $2.62 $1.56 0.94% 60.74% 0.00% 24.40% 1 $6,801
Amer Intl Grp AIG $1.18 $1.99 966.67% 49.91% -1.75% 1.34% 1 $56,865
Silicon Graphic SGI ($0.05) ($0.55) 142.86% 43.75% -4.15% 10.64% 2 $541
Imperial Oil Lt IMO $1.21 $0.54 18.52% 22.22% 0.00% 12.46% 1 $40,108
Hollyfrontier HFC $2.56 $1.24 18.12% 20.41% 3.05% 29.30% 1 $3,829
Constant Contac CTCT $0.01 ($0.03) 14.29% 20.00% 0.00% -2.00% 2 $743
Copa Hldgs Sa-A CPA $0.71 $0.60 35.77% 15.78% 1.50% 3.76% 1 $2,983
Alon Usa Energy ALJ $0.46 ($0.55) 47.62% 15.35% 51.80% 270.00% 2 $610
Suncor Energy SU $0.74 $0.48 73.02% 13.59% 0.00% 0.56% 1 $62,376
Pepco Hldgs POM $0.29 $0.34 35.00% 12.82% 0.00% 0.42% 2 $4,488
Orbotech Ltd ORBK $0.52 $0.45 62.50% 9.09% 0.00% 6.86% 1 $543
Basic Egy Svcs BAS $0.37 ($0.31) 900.00% 8.93% 4.16% 12.81% 1 $1,372
Om Group Inc OMG $0.77 $0.67 59.38% 8.54% 0.00% 16.37% 1 $1,266
Delek Us Hldgs DK $0.58 $0.23 40.91% 8.14% 0.00% 11.88% 1 $911
Youku.Com- Adr YOKU ($0.06) N/A 22.22% 8.00% 0.00% 23.53% 2 $2,812
Grupo Galic Adr GGAL $0.41 $0.10 21.05% 7.89% 0.00% 1.46% 1 $1,732
Siemens Ag-Adr SI $2.61 $2.05 98.37% 6.67% -0.29% 0.41% 2 $120,787
Pan Amer Silver PAAS $0.76 $0.17 9.09% 4.80% 0.00% 13.05% 1 $3,270
Huntsman Corp HUN $0.49 $0.29 95.83% 4.59% 3.16% 8.36% 1 $4,650
Aveo Pharmaceut AVEO ($0.78) ($0.50) 500.00% 4.49% -2175.00% -10.34% 1 $839
Embraer Air-Adr ERJ $0.47 $0.39 70.59% 4.13% 0.00% 0.65% 1 $5,773
Usana Hlth Sci USNA $0.75 $0.69 4.48% 4.05% -0.26% 0.51% 2 $528
Triple-S Mgmt-B GTS $0.57 $0.67 18.92% 3.66% 0.00% 0.79% 2 $641
Transdigm Group TDG $0.99 $0.86 13.25% 3.54% 1.51% 2.56% 2 $4,663
Targa Resources NGLS $0.37 $0.23 54.17% 3.50% 0.16% -0.51% 1 $3,100
Liquidity Svcs LQDT $0.15 $0.12 80.00% 3.45% 0.00% 4.91% 1 $647
Helix Egy Solut HLX $0.19 $0.18 166.67% 3.38% 0.00% 0.00% 2 $1,769
Caci Intl A CACI $1.16 $0.96 12.62% 3.23% 2.73% 3.59% 2 $1,956
Capital One Fin COF $1.66 $1.78 46.41% 3.08% 0.00% 0.86% 2 $24,184
Park National PRK $1.11 $1.30 31.63% 3.03% 0.53% -0.43% 2 $1,020


 
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