When IBM announced surprisingly good earnings on July 21--almost double analysts' expectations--the stock leaped over six points in one day. Similar upbeat earnings reports are accumulating in industry after industry for the second quarter. Investors should pay close attention to this trend. Since falling interest rates are no longer giving stocks a boost, favorable news about earnings increasingly is becoming the main driver of future appreciation in share price.
Earnings reports are a crucial window on the health of a company, but a more telling indicator for investors is how those earnings compare with Wall Street's predictions. If analysts projected profits at Company A to grow 5%, a 10% gain would be bullish. But the same performance would be a disappointment if analysts had predicted a 20% surge. Studies have demonstrated over the years that investing based on positive earnings surprises can sweeten returns. "It improves your odds," says Melissa Brown, research analyst at Prudential Securities. "There's a higher probability of outperforming the market."
ROACH RALLIES. If earnings come in at the expected rate, those expectations will already have been built into the share price and the stock shouldn't move much. But with earnings surprises, there's generally a lag of three to six months--sometimes a year--before the market factors a company's enhanced potential into the stock price. In addition, one earnings surprise tends to lead to another. (This is known as the "cockroach" theory, because you never see just one.) While 15% of companies follow a positive or negative earnings surprise with the opposite result in the next quarter, 40% go on to repeat the surprise, says Brown. That means even if you didn't snap up the stock after the first surprise, you can still capitalize on the likelihood of the next one.
Some investors don't want to wait for earnings reports. Instead, they try to foresee surprises by tracking how analysts are revising their estimates. If estimates are steadily being adjusted upward, it's a signal to buy, and when they're being lowered, it's a good idea to sell, says Ben Zacks of Zacks Investment Research in Chicago. "In general, you're going to be in the right stocks early and out of the bad ones early."
That strategy has worked well for Zacks. His model portfolio--which is based on changes in the earnings outlook--has returned more than 38.5% a year for the past 15 years, vs. 14.5% for the Standard & Poor's 500-stock index. He has gotten even better results with the $20 million he manages for high-net-worth individuals and institutions. His returns after management fees were 76% for 1993, and are 16% for the year to date. That compares well with the figures for the S&P: 10% and -3.8%, respectively.
Until recently, mnly brokers and institutional investors had access to ongoing analyst revisions. Now this information can be obtained by individuals as well. Zacks publishes Analyst Watch, a biweekly listing of regular earnings
estimates and analysts' recommendations ($249 a year; 800 399-6659). For his subscribers, Zacks also provides a hot line for more frequent updates. Working in conjunction with the CNBC cable-TV network, I/B/E/S International, a financial information company, provides a phone number (900 255-2622) you can call for current revisions and earnings information about any stock. The charge is $2 per minute.
Of course, like any indicator, earnings surprises have to be read in context. You want to know the story behind the surprise: whether it's a one-time-only factor, such as the sale of an asset, or a fundamental change in the business, such as a corporate restructuring, says Ed Keon, vice-president of marketing at I/B/E/S. For example, on July 27, Biogen announced second-quarter earnings of 2 cents per share, less than the 12 cents analysts had expected. And yet the stock rose 15 1/4, to 44 3/4. What accounted for gain? On the same day, the company announced a new drug to treat multiple sclerosis.
BIG PICTURE. Watch the stock-price movement in the days before the earnings are due to be announced. Investors who are anticipating good news may run up a stock early, then cash out right after the actual numbers are released. The results may still be a surprise to most investors, but be wary of quick-buck artists taking profits and driving the stock price down.
You also have to pay attention to the larger picture. The recent spike in interest rates is still damping some stock prices despite earnings surprises. And a positive surprise may not buoy a company's stock price against a floundering industry. You also need to know something about the stock's history. Is it way down from its high, or is it near the top? "A stock cycle is like a great party," says Jonathan Schoolar, manager of the AIM Weingarten fund. "People arrive, have a few drinks, and start having fun. More people arrive, but at some point you look at your watch because the pain of tomorrow is no longer worth the fun of today." When analysts stop upgrading their estimates, he says, the party is probably over.
EARNINGS REPORTS: SURPRISE! SURPRISE! Expected Actual Date of Stock price Stock price 2nd Q EPS EPS report before report after report POSITIVE EARNINGS SURPRISES ALCOA $0.29 $0.50 7/8 75 7 77/8 APPLE 0.35 0.50 7/22 28 31 BANK OF NY 0.82 0.92 7/14 29 30 3/8 IBM 0.69 1.14 7/21 56 62 MOTOROLA 0.58 0.63 7/11 45 51 NEGATIVE EARNINGS SURPRISES BETHLEHEM 0.30 0.14 7/27 22 20 7/8 STEEL BORDEN 0.14 0.08 7/27 12 1/4 11 3/4 KEMPER 0.89 0.81 7/26 61 60 DATA: I/B/E/S INTERNATIONAL INC. ROB DOYLE/BW