A Complete Guide to Equity Research - Part 3

Equity Analysts Part 3: Trading Strategies with Analyst Forecasts

In this third part of our series on equity analysts, we are going to explore a series of trading strategies that are made possible thanks to quantifying analyst forecasts. By the end of this article, readers will be more acquainted with the following subjects:

• How to quantify analyst forecasts;
• What are earnings surprises;
• How to form profitable trading portfolios with earnings surprises.

Analyst Forecast Errors Analysts issue several different types of forecasts related to both company performance and accounting metrics. However, the most common forecast that analysts provide is the earnings per share (EPS) forecast, which is the company's quarterly or annual profits being divided by the number of outstanding shares. As with all forecasts, EPS is hardly ever accurate; and we track the analyst forecast error (FE) by measuring the difference between the forecast and the actual EPS. FE is worthwhile to take the time to analyze this metric as it conveys important information. We have already discussed in the first part of the series how analysts’ conflicts of interest tend to lead to biased forecasts, and this phenomenon can be measured by FE. A biased forecast occurs when an analyst’s mean FE is always skewed to the negative or position. Incentives to always have a positive or negative bias depends on the analyst’s current and future connection to the company, either socially or more formal appointments. Although biased forecasts are widely acknowledged, it is possible to garner a reliable estimate of the expected EPS of a firm by averaging all the analysts’ issued forecasts. The errors should be attenuated via this averaging process, and we call this average forecast the consensus forecast. This consensus forecast plays an important role in the stock market, as it provides the best estimate of a firm's value, as evaluated by specialists who should be informed, market participants. Earnings Surprises Share prices should incorporate all relevant information in real time, at least according to the efficient market hypothesis. This theory postulates that stock prices will only shift significantly when new information is revealed to the market. Since the consensus forecast has incorporated all relevant information, any deviations between the actual EPS and the consensus forecast effectively constitute new information. When the actual EPS exceeds the consensus forecast, the market reassesses the firm as possessing higher earnings potential than was previously believed. Conversely, if the actual EPS is lower than the consensus, the sentiment towards the company becomes negative. This difference between the actual EPS and consensus forecast is referred to as the earnings surprise. Profitable Trading Portfolios Naturally, the earnings surprise has a significant impact on stock market performance. There is a strong correlation between the direction of earnings surprise and stock price movements, and the magnitude of the surprise is usually also reflected in price changes. Most price adjustments occur rapidly within the day, and then the price continues to drift in the same direction over a period of several days. This drifting tendency is often referred to as the Post Earnings Announcement Drift (PEAD) and contradicts the efficient market hypothesis. The PEAD anomaly is still observed in the market today. The most widely accepted explanation is that investors underreact to the news. Earnings surprises and PEAD provide excellent opportunities to profit from the stock market, for example:

1. Every earnings quarter, rank the magnitude of immediate past quarter earnings surprises by their direction and magnitude of surprise (to ensure no lookahead bias).
2. If the stock lies in the top rank (e.g. top decile), buy it, if at bottom rank, sell it (if shorting allowed).
3. Continue to build your portfolio in this manner and hold it until the week before the next quarterly announcement.

Returns from this strategy can be highly profitable, but it could be difficult to execute this strategy in inefficient markets or markets where there is private information leakage. The US Regulation Fair Disclosure (discussed in the 2^nd article), helps to ensure that stock prices react before the information is officially announced to the market. Investors should look out for such regulatory safeguards to protect their interests. There are several other ways to profit from earnings forecasts revealed by analysts, and one should systematically look at the forecasts in order to avoid any investment mistakes.