A few weeks ago a question came to me: how can we best predict a company's earnings growth? So I designed an experiment to answer that question. The experiment is a little complicated, so I'll discuss it at the end of this article. I'll instead lead with my results, in reverse order: the factors most likely to predict future earnings growth.
In a tie for fourth and fifth place, with a 25% advantage over a random selection:
Stocks with strong operating earnings growth as measured by comparing the most recent quarter's operating earnings (or EBIT) to the same quarter last year and dividing by the absolute value of the latter
Stocks with strong volume-weighted momentum, as measured by the ratio of the three-week volume-weighted moving average to the ten-month volume-weighted moving average.
On the whole, I found that measurements of past earnings growth were relatively useless for predicting future earnings growth. In fact, there tends to be a reversion to the mean. The stocks whose earnings per share have grown the most over the last twelve months are less likely to exhibit strong growth over the next twelve months than a random selection. But there was one exception: operating income growth, as measured by the most recent quarter. And indeed, if you look at Seeking Alpha's articles on individual stocks, they very often use precisely this comparison. It's a damn good one.
As for volume-weighted momentum, the reason this works is that companies with strong growth prospects attract investors, who bid up the price and are increasingly interested in buying shares.
In third place, with 32% and 26% advantages:
Stocks with low cash-flow accruals, as measured by the difference between net income and operating cash flow, divided by total assets (32% advantage); and stocks with low balance-sheet accruals, measured by the difference between the average net operating assets the last twelve months and the previous twelve months, divided by average total assets over the last two years (26% advantage).
If your net income is low or negative but you have good, strong operating cash flows, you're likely to see a nice increase in earnings in the near future. The same is true if you're lowering your net operating assets efficiently (see my piece on this measure here).
In second place, with 34% and 33% advantages:
Stocks with a high current quarter's EPS estimate as compared to the actual (GAAP) EPS the same quarter last year (34% advantage), and stocks with a high current fiscal year's EPS estimate as compared to the actual (GAAP) EPS last fiscal year (33% advantage). The actual formula is to take the difference between the estimate and the actual and divide by the absolute value of the actual (if that absolute value is less than five cents, then divide by five cents instead).
I don't pay attention to analyst ratings or target prices. But analysts definitely have a bead on future earnings.
And now, in first place (drum roll, please), with 42% and 41% advantages (the gold medal goes to . . .):
Companies with the lowest net profit margin (42% advantage) and lowest return on assets (41% advantage) are the companies with the highest earnings growth potential.
This may appear confounding at first, but it makes sense. These are companies with very low earnings and very high sales (if you're looking at profit margin) or very high assets (if you're looking at ROA). They thus have the highest potential for growth.
Factors that made relatively little difference to growth potential include those based on free cash flow, analyst ratings, asset turnover, and many others. Companies with high returns--whether that be return on capital, return on equity, or high margins--were significantly less likely to experience strong earnings growth than the average company.
Now, of course, there are plenty of other things to look at when considering buying shares in a company than its potential for earnings growth. But it appears to me that investors should be cautious when using measures like ROA, profit margin, and previous EPS growth--which are all negatively correlated with future earnings growth--when looking at which stocks to buy.
Now here's the experiment. First, I chose a factor. Using Portfolio123, I ranked the stocks in the Russell 3000 according to that factor fifteen months ago, and chose those ranked in the top quintile (20%)--about 600 stocks. Then for each of those stocks I looked at the percentage change between the most recent four quarters' EPS and that of the previous four quarters. If the stock had more than a 15% increase in EPS, it got a point. (The reason I ranked the stocks fifteen months ago and then looked at trailing twelve-month EPS growth now is because I wanted to make sure there was no overlap between the factor measurement and the EPS reporting.) Now I had a number--out of those 600 stocks in the top quintile, 266 (for example) reported EPS growth higher than 15%. And I could compare that number to a baseline, which would be derived by looking at all the Russell 3000 stocks and dividing the number with EPS growth higher than 15% by five. I then moved the entire experiment back two years, four years, six years, and eight years, and repeated it. And I tested a large number of different factors.
So, considering these criteria, which are the stocks most likely to experience strong EPS growth over the next year?
Well, currently there are no companies in the Russell 3000 that are in the top quintile for all of these measures. But we could use a ranking system instead. If we take the eight winning factors and weight them evenly, the top ten stocks in the Russell 3000 right now are: Crocs (CROX), DMC Global (BOOM), Molina Healthcare (MOH), Twitter (TWTR), Kadmon Holdings (KDMN), Casella Waste Systems (CWST), Fluidigm (FLDM), Splunk (SPLK), Chegg (CHGG), and Envestnet (ENV). Now I would not recommend investing in all these stocks by any means. You not only want growth, but growth at a reasonable price. I do, however, predict that their EPS growth over the next fifteen months will be strong.
As for stocks I would recommend, Russell 3000 stocks with tremendous EPS growth potential that also rank highly in the evaluation system I intend to shortly offer to the public, they are: Verifone Systems (PAY), Diodes (DIOD), Unisys (UIS), L.B. Foster (FSTR), Heidrick & Struggles International (HSII), Bloomin' Brands (BLMN), Acorda Therapeutics (ACOR), Citrix Systems (CTXS), Orthofix International (OFIX), and Endurance International Group Holdings (EIGI). All of these companies are in the top five percent of both ranking systems.
Disclosure: I am/we are long FSTR. 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.