Seeking Alpha

How To Profit From Stocks With Better Than Expected Earnings

by: Andres Cardenal, CFA

Academic research has proven that companies that deliver earnings numbers above expectations tend to produce superior returns over the long term.

Introducing a quantitative strategy focused on companies consistently beating earnings expectations and driving increased expectations about future performance.

The backtested performance numbers are clearly promising.

The main idea is not to use the quantitative screener as portfolio recommendations but rather as a source of ideas for further research.

At the end of the day, a stock is simply a share in the ownership of a business, and market prices are reflecting a particular set of expectations about the earnings power of such a business. If the company can prove to investors that it can consistently do better than expected, then the stock price will most probably increase in order to reflect increased earnings expectations. As a matter of fact, academic research has proven that companies announcing better than expected earnings tend to outperform the market over time.

With this in mind, the following paragraphs will be presenting a quantitative investing strategy that selects companies producing consistently better than expected earnings. The backtested performance numbers are quite strong, with the strategy outperforming the market by a considerable margin over the long term.

The strategy is not intended as a list of portfolio recommendations but rather as a source of ideas in stocks with interesting characteristics for further research.

Strategy Design

To begin with, we exclude companies with a market capitalization value below $250 million to guarantee a minimum size for the companies in the portfolio. After that, the strategy requires companies to have delivered earnings numbers above Wall Street expectations in each of the past four quarters. In addition to this, earnings expectations for the current year need to be higher than they were 4 weeks ago and also 8 weeks ago.

The main point is focusing on only companies that are consistently beating earnings expectations over the middle term and also generating improving expectations for future performance.

Among the companies that meet the requirements above, the strategy selects the 25 stocks with the strongest metrics according to the Stocks on Fire ranking algorithm. This algorithm is a stock-picking tool based on two main return drivers: price momentum and fundamental momentum.

Winners tend to keep on winning in the stock market. Besides, money has an opportunity cost, and when you buy a stock with subpar performance, that capital is not available for investing in stocks with superior strength. You don't just want to buy stocks that are performing well, you want to buy the stocks that are also performing better than others.

The price momentum metric in the Stocks on Fire algorithm measures price performance over different time frames - the past three months, the 3 months period three months ago, etc. - in order to identify consistent price winners.

The fundamental momentum factor in the Stocks on Fire algorithm measures the adjustment in sales and earnings expectations in order to find companies that are generating rising expectations about future performance. The bigger the percentage increase in earnings and sales estimates, the stronger the ranking in terms of fundamental momentum.

The Stocks on Fire algorithm has delivered market-beating performance over the long term. The chart below shows backtested performance numbers for companies in 5 different Stocks on Fire buckets over the years.

Data from S&P Global via Portfolio123

Companies with high rankings tend to produce superior returns, and stocks in the strongest bucket materially outperform the market. This shows that the system is not only effective but also consistent.

Wrapping up, the quantitative strategy is looking to buy only companies delivering earnings numbers above expectations and enjoying upward revisions in earnings forecasts. Among those names, the strategy selects the 25 names with the strongest rankings in terms of both price momentum and fundamental momentum together.

Backtested Performance

The backtested performance assessment assumes that the portfolio is rebalanced monthly and trading expenses are 0.2% per transaction. The benchmark is the Vanguard Total Market ETF (VTI).

Since January of 1999, the strategy gained 527% versus 288% for the Vanguard Total Market ETF. In annual terms, the strategy Alpha was 3.7% per year.

Data from S&P Global via Portfolio123

The strategy has significantly outperformed the market in the long term, but it also has higher volatility, and it has underperformed in the past year. This is to be expected since even the strongest strategies with the best long-term performance tend to go through periods of underperformance from time to time. Besides, the strategy is more concentrated than the benchmark, and it has a bigger exposure to growth stocks, which explains the higher volatility levels.

The table below offers more information regarding returns for different periods and risk metrics for the quantitative strategy.

Strategy VTI
Annualized 9.31% 6.80%
One Year -3.26% 2.34%
Five Year 67.81% 57.87%
Total 527.12% 288.36%
Sharpe Ratio 0.42 0.40
Sortino Ratio 0.59 0.52
Max Drawdown -59.27% -55.66%
Standard Deviation 23.85% 15.15%
Correlation 0.68 -
R-Squared 0.46 -
Beta 1.07 -
Alpha (annualized) 3.69% -

Stock Picks

The table below shows the 25 stocks currently picked by the quantitative strategy. Data in the table also includes market capitalization in millions and the magnitude of the most recent earnings surprise in percentage terms.

Ticker Name Market Cap Surprise%
APPS Digital Turbine Inc. $538 75.13
RCII Rent-A-Center Inc. $1,395 5.79
RNR RenaissanceRe Holdings Ltd. $8,379 30.25
GLOB Globant SA $3,614 1.05
FCN FTI Consulting Inc. $4,011 78.96
OKTA Okta Inc. $14,630 9.78
SHOP Shopify Inc. $40,369 230.34
OTCPK:HMCBF Home Capital Group Inc. $1,097 11.85
WRB Berkley (W.R.) Corp. $13,230 28.03
SPNS Sapiens International Corp NV $917 11.76
ELF e.l.f. Beauty Inc. $819 127.13
GH Guardant Health Inc. $9,422 62.84
AEM Agnico Eagle Mines Ltd. $14,004 295.26
LAD Lithia Motors Inc. $3,007 4.78
TDG TransDigm Group Inc. $28,249 14.52
VCYT Veracyte Inc. $1,237 42.86
OTC:WJAFF WestJet Airlines Ltd. $2,678 539.56
ACGL Arch Capital Group Ltd. $16,094 14.92
CMG Chipotle Mexican Grill Inc. $22,656 6.07
SSRM SSR Mining Inc. $1,892 40.93
FTDR Frontdoor Inc. $4,262 43.75
SAH Sonic Automotive Inc. $1,164 31.77
G Genpact Ltd. $7,772 5.96
MEDP Medpace Holdings Inc. $2,820 27.56
PG Procter & Gamble $298,516 4.64

It's important to keep in mind that the strategy does not include any criteria for sector diversification, and it also leaves aside other important considerations such as valuation for the stocks in the portfolio. This is to keep the strategy simple and straightforward.

However, investors considering any of these names should take a deeper look at the particular business from both a qualitative and quantitative perspective. The fact that the company is consistently beating expectations is a good reason to take a deeper look at it but not enough reason to buy the stock without further research. In other words, the research process starts with the quantitative strategy, it does not end there.

That being acknowledged, investment ideas supported by hard data tend to produce superior returns in comparison to buying stocks based solely on subjective opinions and emotions. When a company is consistently beating market expectations, this says a lot about its fundamental strength and the quality of its management team.

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 (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.