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Summary Buying stocks with recently upgraded earnings is a well-documented and profitable strategy. How does trading costs impact the return of this strategy? What are 2 other factors that can enhance return of stocks with positive earnings revisions? The American Association of Individual Investors is an interesting resource for investors who want to see historical performance for a wide-range of value, growth, momentum and guru-type strategies. One basic strategy that has been of great interest to me for many years is buying after a positive earnings forecast revision . Since 2000, the strategy (as reported by AAII) returned 25.9% annually with an annual performance of -18.1% in the year 2008. Over the past 15+ years, only 2 years ended with a negative return. It would seem like a simple slam-dunk. But before you start hitting the ‘market order’ button – you may want to read about a hidden danger in addition to a couple of enhancements to this strategy. What Is the Earnings Revision Strategy? The concept is very basic. Analysts typically estimate future earnings. The various estimates are averaged and called a consensus. When the analyst consensus rises by 5% or more, you buy and hold for the following month (or some other length of time). Why Might This Work? The thought is that investors, while aware of the earnings revision, are hesitant to fully price this new information in. The price often drifts upwards for 30 days or more after the initial spike that follows the upgrade. Who Might Like This Strategy? This would be a strategy for an active trader. The turnover is bound to be high. Thus, the trader needs to have skill in purchasing (selling) stocks without unduly driving the price up (down). Does This Simple Concept Really Work? The short answer is, yes – but not as high or as consistent as one would hope. We will look at why in a moment. Before we do so, I wanted to run my own independent test of this phenomenon. Gross Returns of Earnings Revision Strategy Utilizing Portfolio123’s back-testing engine I ran a simple test. I stipulated that earnings must be positive and that the current estimate must be 5% greater than it was 4 weeks ago. There are no other rules. This screen is run across all stocks trading on all USA exchanges which have at least some fundamentals. (click to enlarge) The returns are not as high as AAII’s screen but significant outperformance is present on a massive pool of stocks. The Hidden Cost of Trading If you have ever tried to re-create some of the higher performing screens, you may have learned that simple stock screens often have massive hidden costs. Many of the stock recommendations in this screen come from illiquid tickers with huge bid/ask spreads . You may not be able to buy and sell hundreds of thousands of dollars per stock without moving shares 5 – 10% against the trade. So to get around this, you can raise the minimum criteria which will lower trading costs. What would be the impact if you boosted the minimum requirements to the criteria below? Minimum share price $5 Minimum average daily turnover value of $500,000 Minimum market capitalization of $50 million Increasing liquidity lowers trading costs but also gross performance. (click to enlarge) And once you factor in even a very reasonable amount of slippage per trade, your returns will struggle to remain positive. A good idea also needs a well-executed plan. Going to the open market and buying up stocks with a minimum of 5% earnings revisions without any further consideration can destroy capital fast due to high trading costs but also lower than expected alpha if you trade super-liquid tickers. Yet, we do not throw out the earnings revision strategy because of this. We need to consider other factors that play nice with earnings revisions. What other criteria should we be on the lookout for? Size Matters When it comes to revisions in earnings estimates, stock size matters. To prove the point, look at the performance difference (annualized returns since 1999) between the smallest and largest stocks in the Russell 3000 universe. What does this chart mean? The only stocks represented in the chart are Russell 3000 stocks with a 5% or greater earnings revision. Next, I ranked stocks weekly according to market capitalization. The red bar on the left represents the S&P 500 annual return since 1999. The next bar represents the annual return of stocks that ranked in the bottom one-fifth of the universe according to market cap. The bar farthest right represents the largest capitalization stocks which also had a 5% earnings revision. Therefore, if you are timing a short-term trade based on a revision of earnings consensus, you might be less inclined towards buying larger firms. Some big names that revised current fiscal year earnings upwards over the past few months are Amazon (NASDAQ: AMZN ), AT&T (NYSE: T ), Gilead Sciences (NASDAQ: GILD ) and Ford (NYSE: F ). It would seem that any additional value added by such a revision gets priced in quickly in these highly traded stocks. Therefore, trying to jump on a trade after the revision may not produce the desired results. There appears to be a greater likelihood of an upwards drift in smaller names such as Aceto Corp (NASDAQ: ACET ), Concert Pharmaceuticals (NASDAQ: CNCE ) and Exar Corp (NYSE: EXAR ) which have very small market capitalizations. Value Matters Another important concept relating to upgraded earnings is value. If the share price is very low compared to the earnings, perhaps at a multiple of 10x, and then earnings are forecast upwards by a significant amount – one would expect the price to rise accordingly. But if the price was already trading at a very high PE ratio, perhaps 50 or more, and the earnings forecast was bumped up giving the stock a projected PE ratio of 47 – the upwards price drift may be slight to non-existent. Determining if the projected PE is high or low becomes increasingly important when trading big stocks with earnings upgrades. Over the past 10 years, S&P 500 stocks which had a projected PE ratio higher than average (in this case the average of the R3K index), had an annual return of 6% if you rebalanced weekly. S&P 500 stocks with revised earnings which had lower than average projected PE ratios showed an annualized return of almost 15%. If you traded only Russell 2000 stocks (small-cap), then the’ lower than average’ forward PE ratio stocks would have returned 33% annually over the past 10 years vs. 20% if the projected PE ratio was higher than average. Trading Earnings Revisions Of course, you still have the burden of lowering trading costs to keep as much of this potential return as you can. Here are a few tips I would encourage: Try to keep slippage around 0.25 – 0.35%. You can achieve this by lowering your trading size or moving to slightly more liquid stocks. Also remember that 1 cent represents 1% in a stock trading at $1.00. You may also want to buy higher priced stocks so that you do not lose as much on the bid/ask spread. A rule of thumb is to trade no more than 5% of the daily volume, 10% if you have trading skill. Scan the market for upgrades every week and buy as soon as possible. While you can hold for the full 4 weeks, consider selling early if prices move up very fast. When prices go parabolic, you often do well to lock in profit. If you are holding at the 4 week mark and prices have continued to drift up gradually, analyze if there is reason to hold longer – perhaps an additional 4 weeks. Some stocks continue to benefit from the positive revision longer than the first few weeks. Do you trade earnings revisions? What has been your experience? I would like to hear how you trade this strategy. Scalper1 News
Scalper1 News