Ahead of the market
The zack’s method for spotting stocks early – in any economy
Description
Wall Street analysts provide stock research reports to guide investors. However, blindly following individual analysts' recommendations has risks. A better approach tracks the consensus of many analysts over time.
Specifically, focus on revisions in earnings estimates across analyst reports. Rising consensus estimates predict outperformance. Falling estimates predict underperformance.
By aggregating many analysts' shifting opinions, investors can make smarter decisions. This avoids relying on lone analysts who may provide biased or inaccurate advice.
Table of contents
01Investment plan #1 – track estimate changes
This strategy centers around purchasing whichever stocks get positive earnings estimate revisions from analysts and selling those stocks which have their earnings estimates revised downwards. The strategy tracks the estimates of numerous analysts, not just one or two. It works due to two primary elements:
First, the “analyst creep” phenomenon, where when a stock gets an upward revision in its earning estimate, it is more likely to get more upwards revisions from other analysts over the next month or so. Moreover, research into analyst reports shows they have historically tended to be overly optimistic in their initial earnings forecasts. Thus, they are more likely revising earnings projections down rather than up. So, if an analyst revises earnings projections upwards one month, there is a strong chance they will do the same in subsequent months too. Those continual earnings projection upgrades should convert into solid stock price gains over time.
Additionally, most analysts fear differing from the crowd in case they are wrong. So, even a very bullish analyst will not disclose full optimism at once. Instead, the analyst will partially upgrade, and see how others respond before being bolder. This “herd behavior” underlies the probability of further earnings upgrades down the line.
Second, there is normally a small lag between when an institutional investor decides to act and when it can execute orders. Hence, smaller and nimbler investors can purchase stocks with upward earnings revisions before institutional investors. This allows benefiting from the more gradual stock price appreciation to come. The herd conduct of analysts is a factor here too. Above all, an analyst does not want to miss something every other analyst included. It is preferable to be incorrect with peers than alone.
“Despite research, analysts do not truly know what a company will earn next quarter. Thus, it usually makes sense for an analyst to err on the side of caution with the herd, rather than stick their neck out.” Large, uncommon estimate changes without accompanying analyst moves may signal an analyst lacks a firm grasp on the company. So, analysts make incremental changes, in small steps.
02Investment plan #2 – trade on surprises
The investment strategy outlined involves buying stocks of companies that report better-than-expected sales or earnings and avoiding or selling stocks of those that report lower-than-expected results. This approach is based on the observation that even after public announcements, there is still potential for stock price movement that can benefit investors.
The strategy works primarily due to two phenomena: the post-earnings announcement drift and the "Cockroach Effect." The post-earnings announcement drift suggests that stocks of companies reporting higher-than-expected earnings tend to see an immediate price increase and generally outperform the market for the next three months. This trend continues until the next earnings report, making it a viable strategy to buy these stocks and hold them for about three months before selling them just before the next earnings announcement.
The "Cockroach Effect" refers to the likelihood of companies that have previously reported positive earnings surprises to do so again. Historical data from June 1991 to September 2002 shows that 68% of companies that had previously surprised positively did so again in subsequent quarters. This effect is well recognized by the market, and as a result, such companies are often valued higher due to anticipated continued positive performance.
03Investment plan #3 – combined approach
Combining strategies for stock investment can significantly enhance one's portfolio performance. A particularly effective approach involves closely monitoring analysts' reports on various companies. This can be done either manually for selected stocks or through subscription services like Zacks, which amalgamates analysts' reports for over 4,300 stocks into a comprehensive ranking system.
The core idea behind this strategy is to leverage the collective insights of analysts to mitigate individual biases and to anticipate the stocks that will attract institutional investors, thus benefiting from the resultant stock price appreciation. This method relies on tracking four key factors: the consensus among analysts regarding earnings revisions, the magnitude of consensus estimate changes, the potential upside as indicated by the gap between consensus estimates and the highest analyst estimate, and the historical frequency of positive earnings surprises from the company.
These indicators can be manually tracked using spreadsheet software or through subscription services that automate this process. Zacks, for example, offers "The Zacks Rank," which evaluates these factors for 4,300 stocks based on 30,000 research reports from 3,000 analysts. Since its inception in 1980 up to September 2002, a portfolio based on Zacks' "Strong Buy" stocks would have yielded an average annual return of 31.8%, significantly outperforming the S&P 500's 12.6% in the same period.
04Investment plan #4 – leverage rating shifts
If you simply buy the stocks that analysts rate as a “Strong Buy”, you will probably do well in a bull market but not as well in a bear market. A better approach is to select stocks based on changes in analysts’ recommendations over time. The emphasis of this strategy is to focus on changes to the consensus recommendation score to generate buy and sell signals. Analysts are always reluctant to issue sell recommendations for stocks for a few key reasons. First, they risk upsetting the company’s management, which means management is less likely to provide the analyst timely information in the future. Second, it becomes less likely the company will give that analyst’s firm any future investment banking business, which is very lucrative for investment banks. And third, nobody likes to deliver bad news. Therefore, if an analyst actually issues a sell recommendation, that is a strong sign the stock will likely underperform the market over the next two to three months. Any sell recommendations warrant close attention from an astute investor.
With this bias towards positive recommendations in mind, the optimal way to utilize analyst recommendations is through “piggybacking”. This entails examining the recommendations of multiple analysts together. If most of the analysts are upgrading their recommendations, that indicates some positive development may be approaching and the stock will outperform over the short term. The earnings estimates are the most useful information in any analyst report because they can be validated against actual results every quarter. All other sections, including buy/sell recommendations, are far less definitive and sometimes misleading. Next most important are the long-term earnings growth estimates, though these also tend to be optimistic for most companies the analyst follows. The common use of long-term earnings estimates is calculating price-to-earnings growth ratios and comparing them across peer companies.