Buy Company Stocks For The Real Reason To Buy Stocks
Many have expressed frustration in trading equities over the past few years. Between central banks holding interest rates at inappropriately low levels, official direct intervention (Swiss National Bank, Bank of Japan and undoubtedly clandestine government equity purchases) to support the stock market, and a massive company share buy-back frenzy, investors fearing the lofty equity valuations have just gotten hosed for their prudence. There are many such exogenous factors that drive equity prices, creating overshoots to both the upside and the downside, as a company’s shares temporarily deviate from underlying fundamental values. However in our study of the markets, we have found that individual company stock price moves accompanied by rising/falling earnings estimates tend to be systemically longer-lasting (or permanent) than stock price moves initiated by exogenous macro factors or technical chart patterns.
Although it should not be a surprise that stronger company earnings growth translates into greater stock price appreciation, we find that the average investor has lost sight of this single most important driver of a company’s share price. A stock is simply a share of ownership in a business. Earnings accrue to company owners – the more earnings your share entitles you to, the more your share is worth. Yet we hear other strategists frequently use spurious reasoning to explain to the public why a company’s share price is moving. The talking heads on the financial media networks would have us believe that Donald Trump’s tweets or Jerome Powell’s jawboning should cause a company to gain/lose in market value. In reality, such new items just drive automatic trading algorithms. Moves in a company’s stock due to such news events are most often just short-term noise and remain speculative, unless the company’s earnings are materially affected by the non-company specific news items. Similarly, technicians claim that a company’s stock price should move in accordance with some chart pattern or Fibonacci level. There are even some soothsayers on Seeking Alpha counting Elliot Waves and claiming to predict the extent of a move in a company’s share price purely on their reading of the tealeaves (which of course is always re-interpreted in hindsight when predictions go astray).
While we don’t deny that new events or technical patterns may drive company share prices in the short-run, investors should recognize that timing these trades is a low probability endeavor. At WMA, we believe that the only way to make money consistently in company shares is to trade in-line with company earnings growth. We certainly use technicals to control for risk and improve entry points for all our holdings. But the meat of our company analysis and stock selection revolves around fundamentals and earnings. And for good reason. In our research, we have found that, since 2011, firms with consistently positive EPS revisions have sharply outperformed the median S&P 500 firm with an annualized return of 38% vs. 19%! Companies that had positive EPS revisions tended to buy back stock and exhibit positive sales revisions thanks to increasing margins. Conversely, companies with negative EPS revisions were susceptible to poor market performance. Negative EPS revision firms have lagged the S&P 500 by -15% to -20% on an annual basis.
How long should you hold onto a stock with positive EPS revisions? There is no crystal ball and no wave count to consistently answer this question successfully. The best course of action is to stay with a company as long as earnings are growing.
Regular readers will know that we maintain a ranking system of over 5,000 listed companies broken down into 15 fundamental metrics (or “F-scores”). The valuation measures, profitability, yield, and analyst consensus recommendation F-scores are all pieces of the puzzle useful in constructing a winning portfolio allocation. The F-score associated with forecasted next twelve month-to-trailing twelve-month earnings per share (EPS) and revenue are also a guiding light in stock selection. However, we give the greatest attention to consensus EPS and Revenue revisions F-score. Why? These represent the most up-to-date EPS and Revenue estimates held by analysts tracking a company. As material information that impacts a company’s earnings growth is made public, analysts revise their earnings forecasts up or down. Earnings and revenue growth are therefore not rear-view mirror indicators – using the best forward consensus estimates is the only way to gain tradeable insight into a company’s stock. Sorry, Yahoo Finance or other free data sources won’t help readers here. Obtaining timely analyst reports from brokerage firms comes with a price. We believe that the benefit to our portfolios greatly out-weights the hefty price that we admittedly pay to obtain forward consensus estimate data for all listed companies.
In this article, we explain to novice investors where EPS and Revenue revisions come from, then detail how we use this crucial data in our methodology to help to select the best companies.
Calculating EPS and Revenue Revision Scores
As readers know, investment banks and brokerage houses employ sector analysts. The job of these analysts is to closely follow companies under their coverage, maintain contact with the directors of companies covered, and to understand the business model and earnings/revenue drivers of their companies. In addition to providing a buy/sell/hold “recommendation” for their investment bank or brokerage, analysts formulate earnings and revenue forecasts for the current year and for next year. These forecasts are often guided by the company directors themselves, who obviously have the best visibility of the near-term earnings path of their company.
Earnings estimates are often revised when something new occurs to the company and analysts think that these changes could affect the future earnings of the company. Although earnings estimates are more susceptible to change during “earnings season”, when companies render their quarterly financial reports, analysts may alter their forecast for EPS and Revenue at any time, if material information becomes available to them.
Let’s take an example to make the EPS and Revenue revisions concept more concrete. The consensus EPS estimate for the current year for Microsoft (MSFT) is $4.59 per share. This number is a mean EPS estimate, combining the individual EPS estimates from the 34 industry analysts that follow Microsoft. As an aside, in our methodology, we don’t place much value in “consensus” EPS estimates made for small companies with one or two analysts covering the company. Suppose that the Microsoft current year EPS revisions series looks like this:
|Date||EPS Estimate 2019||3-month EPS Revision||Date of revision change|
|March 6, 2019||$4.00||0%|
|March 7, 2019||$4.00||0%|
|March 8, 2019||$4.00||0%|
|March 9, 2019||$4.00||0%|
|March 10, 2019||$4.00||0%|
|June 6, 2019||$4.59||14.75%||EPS revised higher|
|June 7, 2019||$4.59||14.75%|
|June 8, 2019||$4.59||14.75%|
|June 9, 2019||$4.59||14.75%|
|June 10, 2019||$4.59||14.75%|
|July 6, 2019||$5.00||25.00%||EPS revised higher|
|July 7, 2019||$5.00||25.00%|
|July 8, 2019||$5.00||25.00%|
|July 9, 2019||$5.00||25.00%|
|July 10, 2019||$5.00||25.00%|
|September 6, 2019||$5.00||8.93%||EPS unchanged|
|September 7, 2019||$5.00||8.93%|
|September 8, 2019||$5.00||8.93%|
|September 9, 2019||$5.00||8.93%|
|September 10, 2019||$5.00||8.93%|
Consensus EPS forecasts began the year at $4.00/share. On June 6, the consensus EPS was revised up to $4.59/share. This represented a +14.75% EPS revision. Then suppose that on July 6 the consensus EPS was revised up again to $5.00. This will represent a +25% EPS revision, relative to the EPS forecast 3-months prior ($4.00/share on April 6). Then on September 6, the June 6 EPS revisions will have “worn off” as the 3-month look-back period moves past June 6. The resulting EPS revision on September 6 will then be the current $5.00/share forecast relative to the prior value 3-months ago, which was $4.59/share on June 6. Note that the revision series change falls to +8.93% after the rolling 3-month window moves forward. At WMA, we have found 3-month to be a good time period, as EPS changes tend to become fully incorporated into a stock price after one quarter.
Our WMA EPS and Revenue Revision F-scores are based on the numbers seen in the third column in the above example. Stronger EPS revisions will result in higher scores in our ranking system.
Using EPS and Revenue Revisions In Stock Selection
At WMA, we use our fifteen F-scores differently in classifying companies as Growth, Value, or Yield stocks. The one metric that is omnipresent in our process is the EPS revision score. For us, buying a company with negative EPS revisions is akin to buying a ticket to board the Titanic.
We calculate a 0 to 100 EPS revision score and a 0 to 100 Revenue revision score for each of our 5,000+ companies (provided the data is available and the consensus number is formed from at least several analysts). We then rank each company against all other companies in our 5,000+ stock universe (Global score) as well as constructing a ranking against sector peers (Sector score). Depending on what type of company we are looking for, we can be more or less demanding vis-à-vis our EPS and Revenue revision scores. However we rarely buy a company with a score below 50.0, which signifies a negative change in our average EPS (or Revenue) revisions over the prior 3-months.
Our work has shown that EPS revisions tend to be more powerful drivers of stock prices than revenue revisions. As such, we have built a Daily EPS Revisions Monitor which we use both for idea generation and to reinforce a buy/sell decision for companies in our Watch List.
We know that stocks tend to pop or drop as soon as material news on a company is released. Automatic trading algorithms exist for this purpose. However we have also observed that stocks that enjoy/suffer a positive/negative EPS revision tend to keep trending in the direction that the revision dictates. In other words, stock price movements resulting from an EPS revision tends to “have legs”. If a stock’s “technical” look constructive and our F-scores rank the company favorably, a positive EPS revision is an excellent time to jump onboard the stock.
To illustrate, we share below the first few lines of our Daily EPS Revisions Monitor for June 7. The company’s WMA EPS Revision’s score is shown alongside the point change from the prior day.
While stock prices may not always react immediately to a change in EPS revisions, we find this monitor to be useful in stock selection. First, if a company’s stock price does take-off to the upside (or melts down), then we see a change in EPS revisions on the same day, we are more confident that the stock price move in progress is meaningful and will continue. Second, a positive change in EPS revisions may draw our attention to a potential winning company that the market is over-looking. From this point we can look at our other F-scores, as well a technicals, to motivate a decision to invest in the company.
The best indicators for company selection are Earnings and Revenue revisions. These series provide the timeliest fundamental data on a company with, by far, the greatest potential impact on the stock price. Given the importance of revisions, we calculate two F-scores for each EPS and Revenue revisions to get a couple looks at these important indicators. Focus on companies with positive EPS and Revenue revisions (WMA scores above 50) and use daily changes in the revisions series to get a jump on nascent trends in the stock price.