book.chapter Investment 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. To implement this, you need to track how consensus earnings estimates of multiple analysts change over time: Gather database information – examine what all analysts following a stock forecast for earnings. Web sites providing this include: Moneycentral.msn.com/investor – Click “Earnings Estimates” then “Consensus EPS Trend” Quicken.com – Click “Quotes & Research” then “Analyst Ratings” Morningstar.com – Use Quicktake reports, click “EPS Estimates” and “Annual Earnings Estimates” Zacks.com – Input ticker and click “Estimates” Look for buy signals – whenever consensus earnings estimate for current year rises 3% or more in the past month. Similarly, look for sell signals – whenever consensus earnings projection falls 3% or more in the past month. Evaluate quality of revisions – to determine if sustainable revenue growth or one-time factors caused them. Read some analyst reports for sustainability clues. Act after homework – buy stocks with upgraded earnings, sell those with lowered estimates. “It doesn’t matter the size of the company, be it ExxonMobil or a corner store – the sole determinant of a company's value is what it earns for shareholders.” Earnings matter because they indicate potential dividend payments, giving a stock inherent value. The key question in pricing any stock is not past earnings, but what future earnings are likely to be. Hence, analysts’ future earnings estimates are so important. What analysts expect a company to earn is probably already reflected in its stock price. What matters is not the expected amount, but how those expectations have recently changed. Fundamentally, stock prices respond to upward revisions because they signify improving future earnings potential. When future earnings look better, the stock price should increase too. “If you could perfectly predict analysts’ estimate changes, you could generate phenomenal returns.” You can effectively buy or sell ahead of the market by purchasing stocks with recently upgraded earnings and selling those with downgraded estimates. This lets you anticipate future analyst and institutional investor actions, whose behavior moves prices. Analysts earn over ten times an average stockbroker, frequently over $1 million, with superstars making much more via investment banking revenue. In return, an analyst becomes a world expert on covered companies and is on speed dial for major institutional investors. More influence means more ability to move markets and thus more pay. Analysts rarely issue sell recommendations for three reasons: They don’t want to upset company management and lose access, putting them at an informational disadvantage. They don’t want to alienate institutional investor clients already long the stock who could get burned rushing to sell. More clients want ‘buy’ calls, so they have more value to brokerages for getting new business. Now investment banks use analysts to compete for deals and fees. So analyst pay depends on driving investment banking revenue, pressuring them to appease bankers. Regardless of legislation trying to separate analyst pay from banking fees, markets find creative workarounds. You should not follow analysts that have historically lost investors money or simply pick the most popular. Distinguish between popularity and accuracy. Changes in consensus earnings estimates have a far stronger price movement signal than buy/hold/sell recommendations. Despite extensive research, an individual analyst’s future earnings projections still involve uncertainty. It is safer to move alongside the herd than alone. Analysts change estimates slowly to avoid surprising markets. By tracking changes and acting first, individuals can profit.