I wasn’t always a good investor. Over the past 30 years I’ve made just about every mistake imaginable.
· Jumped in at the peak
· Jumped out too late
· Bought falling knives
· Doubled down on losers
· You name it, I probably did it.
By the time I joined up with Zacks Investment Research in August 1999, I had eradicated most of those bad habits. But as Len Zacks and his brother Ben pointed out…I had a lot to learn.
What they taught me is that, indeed, earnings estimate revisions (EER) are the most powerful force impacting stock prices. And nothing captures that power more than the Zacks Rank rating system as proven by its long term performance.
The timing of this profound investment message could not have been better for me. As the stock market bubble popped in 2000, I started to apply this new investing approach. So even though the market tumbled that year, I actually gained +16% in my personal account.
Was I hooked? Heck yes.
Each year since, my knowledge and passion for this approach has grown. And there is nothing I like more than to share the wisdom of this investing strategy with others. My goal today is to spread some of that wisdom on to you so you can also enjoy great investment success in the years to come. I’m going to do that by listing…
3 Reasons to Use Earnings Estimate Revisions to Pick Better Stocks
1) The Most Fundamentally Sound Metric: There are so many different websites, magazines, books, TV stations etc. dedicated to investments. The amount of information overload is so unbearable that most investors walk away horribly confused about what is truly important to achieve success. So let me simplify the matter for you so you can push away all that noise and nonsense in the future.
At the end of the day, all stock price movements can be traced back to earnings.
Read that line again so it really sinks in. The reason it’s true is from the basic fact that when you buy shares in a company, you are actually buying a percentage ownership stake in that firm. And if you are the owner of a company, big or small, then the single most important metric to gauge success is how much earnings are generated.
If profits go higher than expected, the share price will rise. Conversely, if profits go lower than expected, the share price will come down as well. The stock market has always worked on this premise and it always will. And nothing captures the essence of this notion more than earnings estimate revisions.
2) Applies to Every Type of Investor: Because all stock price movements can be traced back to earnings, it follows that earnings should be at the heart of every investment decision. But that is not the same as saying that earnings are the ONLY thing to consider when selecting a stock. That is just the starting point. From there, each investor can layer on other concepts such as value, growth, charts etc. to find the stocks that fit their unique approach.
My favorite analogy for this is to say that earnings are to stock investing as flour is to baking. That’s because nearly 100% of baked goods include flour in the recipe. What makes each item unique and delicious is the rest of what you add into it (sugar, flavorings, nuts, fruit, butter etc). Each way works out well, but each starts with flour to make it all come together. So you can apply other factors on top of earning and estimates to make it suit your unique investment tastes as well.
3) It WORKS: When you put the philosophy and analogies aside, earnings estimate revisions simply work. This is clearly proven by the market topping +28% average annual returns of the Zacks Rank since 1988. Sure, we got our rear-ends kicked in 2008 just like everyone else. But we have topped the S&P 500 in 21 of the last 23 years, and came roaring back in 2009 and 2010.
We always get asked; “If it’s so good, and so well known, why does it still work?”. Meaning that most of us are taught in business classes that the market is efficient. So if there are any anomalies that help people beat the market, it will be discovered and eradicated due to extensive use.
The reason it keeps working is because institutional investors are the prime users of estimate revisions and they really haven’t gotten any faster over the years. Here is an overly simplified example:
When they see estimates rise for a stock it will look more attractive in their valuation models and they will want to buy up shares. Since most mutual funds are nearly 100% invested at any time, then they will have to sell something else to get a full position in this new stock. They don’t want to sell out too fast of the other positions or they may end up moving the price lower on themselves. And they don’t want to buy up the new shares too fast or they may run up the price on themselves. Long story short, the accumulation and distribution process still takes most firms 2-4 weeks to fully complete. This still gives more nimble investors ample opportunity to get in early on estimate revisions and enjoy the ride higher as the professionals slowly accumulate their shares.
Gladly, you can benefit from earnings estimates without spending any money. That is because most websites have earnings estimates data on their sites and stock screeners that can help you narrow in the stocks experiencing the highest level of revisions.
Here is one last tip. Since EER is so powerful on the way up, it is also very beneficial to folks on the way down. Meaning, you should immediately sell any stock that has negative earnings surprises or lowered estimates. Yes, you may need to sell out after it falls 5-10% on this news. But better to do that early on instead of selling out for 20-30-40% losses down the road.
Some of My Favorite EER Stocks at This Time
1) Anixter (NYSE:AXE): This specialty wire and cable distributor is really hitting its stride at this point of the economic cycle. The last two earnings beats have been impressive with shares pushing new highs. Most signs point to more of the same in the days ahead especially because they are a late cycle earnings play.
2) Baidu (NASDAQ:BIDU): This Chinese internet company is a phenomenal growth story. Shorts keep hoping the good times will end and the P/E will contract. But the company refuses to give in with exceptional earnings growth and subsequent share price appreciation.
3) DuPont (NYSE:DD): Chemicals has been one of the best groups over the past year. The reason is simple. A growing world economy, especially in developing markets, drives great demand for chemicals. Increased volume = increased profit margins = increased share price. DD is certainly a leader in the space with average earnings surprise of 27% over the last 4 quarters. That has shares pressing new highs. Plus, you get the benefit of a hefty dividend.
4) Intel (NASDAQ:INTC): Each of the last few quarters they have provided great earnings surprises, but really shares did not rise. This last beat finally has investors taking notice. Plus, their aggressive R&D plans means they are confident about future growth potential. Shares are only trading at 10X this year’s earnings. That is an outright steal for a company of this caliber.
5) Ryder (NYSE:R): This is a great play on the growth of the economy. As it expands there will be higher demand for the trucking of goods around the country. Ryder is a leading supplier in the space including logistics and rental of trucks. They have provided a string of solid earnings beats including this last quarter’s +16% surprise. Analysts like what they see with estimates on the rise and shares pressing new highs.
Disclosure: I am long AXE.