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Global Outlook

Earnings Surprises

May 9, 2014, Friday, 05:20 GMT | 00:20 EST | 08:50 IST | 11:20 SGT
Contributed by eResearch

Last year, there were roughly 180,000 earnings estimate revisions made by more than 3,500 sell-side analysts employed in the United States. Before we developed the quarterly consensus earnings estimate at Zacks, companies that reported earnings compared those earnings to historical trend-line growth. A good earnings report was a company that was reporting earnings growing above historical growth rates.

For instance, if a company was growing earnings at an annual rate of around 10% over the past five years, and suddenly the reported earnings grew at 12% on a year-over-year basis, the company's earnings were considered good.

At Zacks, we calculated a metric called the consensus earnings estimate. This metric is effectively the average of what all the sell-side analysts following the company are expecting the company to earn on a quarterly basis. Companies soon began to report earnings and, instead of comparing the year-over-year earnings growth to historical levels, the companies began to compare the earnings growth to the consensus earnings estimate that was created by Zacks. Fast forward about thirty years and now company management is focused on a concept called an "Earnings Surprise".

Earnings Surprise

The term “Earnings Surprise” was coined by us at Zacks in 1982. It sounds exotic, but the idea basically boils down to comparing corporate earnings relative to the consensus, or average of what Wall-Street sell-side analysts are expecting the company to earn on a per share basis. When a company reports earnings that are better than the quarterly consensus estimate, it is called a positive earnings surprise. However, when a company reports earnings that are worse or lower than consensus estimates, it is called a negative earnings surprise.

Generally speaking, stocks statistically tend to under-react to the direction of the earnings surprise. The stock of a company reporting a positive earnings surprise will continue to trend up over the next ninety days while the stock of a company reporting a negative earnings surprise will tend to trend down over the next ninety days. Thus, by buying companies that have recently reported positive earnings surprises, an investor is able to generate alpha, or returns that are greater than those of the market. The key question is of course which companies respond best to earnings surprises.


Well, if you delve into the data, something interesting is found. To the extent the company can be hedged by investors, there is less of a response to a positive earnings surprise. This means, if a hedge fund can actively short a similar stock to the stock that reported the earnings surprise, the post earnings announcement drift, or price response to the positive earnings surprise is more muted.

Effectively, hedge funds actively got into the earnings surprise trading game and, as a result, companies that are harder to hedge generally respond more positively to earnings surprises.

Thus, smaller market-cap companies tend to have a greater delayed price response to an earnings surprise. Part of the reason is that, the smaller the market-capitalization of a company, is the harder it is to find a suitable hedge. Also, smaller companies tend to have more idiosyncratic businesses that are harder to hedge. If a company really does not have a peer company, it is difficult for a hedge fund to find a short and, as a result, the earnings surprise will cause the price drift to last for a longer time period.

For instance, if GM reports a positive earnings surprise, it is very easy for a large hedge fund to buy massive amounts of GM and immediately short massive amounts of Ford as a hedge. As a result, most of the price response to the earnings surprise will occur immediately following the earnings report. If, however, the company reporting the positive earnings surprise is a small-cap regional retailer it is much harder to find a comparable company to short. Additionally, the same massive hedge fund cannot easily deploy large amount of assets into the small-cap company quickly, and certainly cannot deploy large amount of assets into the short position quickly. The net result is the post-earnings announcement drift of the small-cap specialty retailer will be greater than the post-earnings announcement drift of GM.

Individual Ownership

Also playing into the equation with regards to post earnings announcement drift is the percentage of the stock that is held by individuals. Stocks are generally held by one of two groups - individuals or institutions.

Stocks that have a greater degree of individual ownership statistically have been shown to have a greater price response to earnings surprises. The reason has to do with something called prospect theory. Prospect theory explains how people emotionally react to gains and losses. When an individual is dealing with gains, they tend to become more risk-averse, and they want to avoid taking additional risks. With losses, people tend to be more risk-seeking. Think of a gambler increasing his wages as he loses more and more in Las Vegas.

A positive earnings surprise essentially puts the holders of the stock immediately in position of dealing with gains. The natural reaction is for an investor to become more risk-averse and, as a result, reduce their exposure to the position, i.e., effectively take money off the table. The individual investor therefore has a tendency to want to cut winners, and let losing positions ride. Very simply, this is the way we are all psychologically wired to deal with gains and losses.

My sense is that institutional investors are less prone to these behavioral biases, or at least have learned over the years to potentially control the biases. At Zacks Investment Management, we try to control these biases by relying on quantitative models.

Putting it All Together

As an investor, you want to use this knowledge to narrow the universe you select positive earnings surprises from. There are some disadvantages to individual investors, but one of the clear advantages for individuals is that you are able to trade stocks that are smaller in market capitalization than larger institutions. Nowhere is this advantage more useful than in trading earnings surprises. My suggestion is to focus on the following types of companies during earnings reporting season:

- Smaller cap stocks

- Stocks that have idiosyncratic businesses

- Stocks which are hard to hedge

- Stocks that are owned more by individuals than institutions

My experience has been that the post-earnings announcement drift in these types of stocks will statistically be the greatest. You will not make a winning trade in every company that reports earnings but, over time, you will be able to generate alpha a greater percent of the time.