Earnings surprises occur when a company's reported earnings diﬀer from the analysts' consensus estimate. This often leads to extreme stock price movements.
It is important to remember that analysts do not develop their earnings forecasts in a vacuum. Analysts depend heavily on corporate executives for information. Working together to create earnings estimates, the analysts and executives share a common interest in managing expectations so as to maintain a positive spin on the company's prospects, while taking care not to set the bar too high. The analysts maintain a pretense of independence when they announce the new forecast, but, in fact, they rarely challenge the estimates given by management.
Hence, a positive earnings surprise means that, in eﬀect, the company outperformed its own expectations. A negative surprise means something went wrong that management was unable (or unwilling) to predict. In either event, the market response will be fairly predictable.
Positive Earnings Surprises
I know from extensive academic research and my own experience over the past 16 years that positive earnings surprises often cause stock prices to rise over extended periods because, when results are better than predicted, more positive surprises generally follow as the story unfolds.
Corporate executives who beat their earnings forecast win accolades (and bonuses) for their demonstrated ability to manage their business. If nothing else, they have shown an ability to manage investors' expectations. Absent any major change in circumstances, they have compelling motivation for encouraging analysts to continue setting artiﬁcially low expectations that the company can easily surpass.
The analysts are only too happy to cooperate, because positive earnings surprises serve their interests as well. Instead of increasing their earnings estimate for a growing company in one large step, they often announce a series of small increases over a period of time, hoping to keep their forecasts below the figure that is ultimately reported. Each announcement fosters goodwill with the company's executives, who are pleased with the positive press and happy that the Street's expectations remain eminently achievable.
At the same time, conveniently, analysts' predilection for incrementalism contributes to their support of brokerage operations. When an analyst raises his or her earnings estimate for a stock, the fact of the increase is more important than the amount. Even a small increase gives the ﬁrms' brokers an opportunity to call their clients and persuade them to buy more stock. A series of incremental increases multiplies the opportunities for generating brokerage commissions, and it increases buying interest by reinforcing clients' positive perception of the company.
Thus, by adjusting their earnings forecast to set up a string of upward revisions and positive earnings surprises, analysts are able to please all of their key constituencies: The corporate executives who supply essential information and may also be investment banking prospects, the brokers who generate commission revenue, and the brokerage clients who, along with everyone else, are delighted with the inevitable rise in the stock's price.
We call this approach the "Sergei Bubka Gambit" in honor of the Ukrainian pole-vaulter who set 35 world records in his event. Bubka had no real competition, and his sponsors paid him a bonus every time he set a new record. Consequently, with no incentive whatsoever to give his best eﬀort, he opted to improve his record one centimeter at a time.
Analysts, emulating Sergei Bubka, in eﬀect, earn bonuses for themselves every time they announce tiny, incremental increases in their forecasts. At the same time, they avoid the risk of going out on a limb with a large upward revision.
Analysts who employ the Sergei Bubka Gambit compound the market impact of corporate executives who sandbag their forecasts. When they understate earnings forecasts, they cause the market's reaction to actual earnings growth to be delayed. A positive earnings surprise may lead many investors to buy the stock, but few realize the full extent of the opportunity. They don't buy as aggressively as they might have, or more likely, they sell before the company's earning power is fully reﬂected in its stock price.
Eventually, the company's operating performance will drive the stock price to a more appropriate level, as public perception catches up with reality. This scenario often creates prime opportunities for superior gains.
Therefore, if a stock meeting my initial screening criteria reports a positive earnings surprise, unless a review of the earnings announcement reveals that the better-than-expected performance is just a one-time event, I immediately and aggressively buy it.
Negative Earnings Surprises
Delay in releasing and reacting to new information can be even more pronounced in the case of a deteriorating situation. Very often, a negative earnings surprise is my ﬁrst indication that things are going wrong with a company.
When a company's plans go awry, managers at all levels tend to put an overly optimistic spin on developments. Few divisional or regional sales managers are willing to risk their jobs by painting a bleak picture of their own unit's prospects. Prophets of doom are rarely rewarded, even if they do manage to keep their jobs, so unrealistically optimistic forecasts tend to get passed up the organization to the senior executives.
The senior executives, for their part, may be inclined to accept and repeat a rosy scenario, rather than face the consequences of going public with the truth. They would rather persuade analysts to defer cutting earnings estimates than go public with information that might well batter their stock and jeopardize their bonuses.
Analysts, as we have noted, react slowly to new information, and very few analysts are quick to blow the whistle on a deteriorating situation. This is especially true when the ﬁrm or its institutional clients hold signiﬁcant positions in the stock, or when the ﬁrm's investment banking division is pursuing a deal with the company.
Besides their need to protect themselves and their key constituents, analysts have a typical human aversion to admitting their mistakes. They will often delay downgrading a stock they have heavily touted until it has become obvious that something is amiss.
Thus, both the executives and the analysts have substantial incentives to keep the company's problems under wraps, buying time in the hope that things will get better.
A negative earnings surprise often will foretell a continuing deterioration of operating performance. Meanwhile, the executives and analysts will be motivated to continue whitewashing the earnings estimates, leading to more negative surprises in the future.
This creates an opportunity to proﬁt from shorting the stock or buying put options upon the announcement of a negative earnings surprise. After the fall in price resulting from the negative surprise has run its initial course, the stock might recover temporarily as a result of the overly optimistic earnings forecasts, wishful thinking by investors who have lost money, and a reduction in margin call-related selling pressure, but then the stock will in all likelihood continue to drift lower as the full scope of the company's problems is gradually revealed.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.