To print article, click Print on your browser's File menu. Go back Posted 12/1/99 "If estimates are being raised, the fundamental outlook of the company is improving, and that's what makes a stock attractive." -- Ben Zacks, Zacks Investment Research	Advertisement Strategies Track the 'numbers bumps' for stock jumps When analysts revise a company's earnings estimates upward, share prices usually follow. Here's how the investment pros use earnings revisions to research stocks, and six stocks that make our list. By Michael Brush Stock analysts. You can love 'em or hate 'em. But they have what you need: Clues about whether a stock is going up or down. As any investment pro knows, however, Wall Street research can be tainted by brokerage analysts' drive to drum up investment banking business -- where the big bucks are made in the typical investment-banking house. It's not good to be too cynical on this point, though, because analysts have plenty of useful information, as long as you know how to tease it out of them and dodge the blatant sales pitches. Start Investing Community Join the discussion in MSN MoneyCentral's Start Investing Community. Each professional money manager has his own bag of tricks for getting the most out of Wall Street research. These days, however, the pros agree that some of the best intelligence comes from analyzing trends in earnings estimates revisions produced by the analysts. Though long the realm of Wall Street technology eggheads, earnings revision analysis, in its basic form, is actually about as simple and intuitive as it is effective. That helps explain why just under half of professional money managers listed earnings revisions among their favorite stock selection gadgets this year, according to a survey by Merrill Lynch. Revisions were the third most popular tool, after earnings surprise and return on equity, which came in first. Boiled down to the basics, earnings revisions are popular because stocks whose estimates are trending upward are likely to outperform those whose revisions are flat or negative. Why? "If estimates are being raised, the fundamental outlook of the company is improving, and that's what makes a stock attractive," notes Ben Zacks of Zacks Investment Research, which supplies earnings revisions data to MSN MoneyCentral. Lost in complexity and secrecy As with any stock selection system, this one has been blunted over the past decade as increasing numbers of investors have flocked to it. In response, Wall Street's quantitative research houses have hired more and more math Ph.Ds to think up more and more complex ways to slice and dice the numbers. You won't hear about their breakthroughs, since the quants worry that revealing their secrets will reduce their effectiveness. They are right. But it doesn't matter. Because even without the complex systems, you can make earnings revisions work for you by consulting databases like IBES International, Zacks Investments, First Call and MoneyCentral's own Investment Finder to get a read on trends in the estimates. Quick Reference What are a company's earnings estimates? What is an earnings surprise? Sectors and stocks getting excellent earnings revisions right now include Xilinx (XLNX, news, msgs), Network Appliance (NTAP, news, msgs) and Remedy Corporation (RMDY, news, msgs) in the technology sector, and Dayton Hudson (DH, news, msgs), Home Depot (HD, news, msgs), TJX Companies (TJX, news, msgs) and Chico's FAS (CHCS, news, msgs) in the retail group. In the oil sector, Occidental Petroleum (OXY, news, msgs), Murphy Oil (MUR, news, msgs) and Atlantic Richfield (ARC, news, msgs) come up strong. Don't buy a stock simply because its revisions are going up, of course. But take it as a darn good sign. At the very least, start your search for winning stocks by screening for companies getting upward "numbers bumps," as revisions are called on the Street. Then do further research on the names that get dredged up. You can be pretty sure that good revisions are a positive sign for two basic reasons. 1. An upward earnings revision is very likely to be followed by more upward revisions. This is good to know, because stocks are priced on forward earnings expectations. To understand this point, put yourself in the shoes of a Wall Street analyst. Suppose you have done homework that leads you to conclude that HotTechStock.com, which you follow, will earn $1 more per share next year than you had thought. The next thing to do is rush out with a press release to beat the competition in announcing the new estimates, right? Wrong, on two counts. First, you know that some random event could come along during the year -- an unforeseen economic downturn, an earthquake -- which could wipe out that extra dollar. So you recognize that it is a lot better to announce only a dime for now.
Glossary • Earnings • Estimates • Earnings Surprise	More importantly, as a Wall Street analyst, you've learned it's much worse for your career to go out on a limb and be wrong, than to play it safe and mess up along with everyone else in the pack. The second scenario is a lot easier to explain to your boss. Not to mention your clients. ("Hey, everyone else screwed up. What's the big deal?!") This is another great reason for you to play it safe and announce only a dime for now. If things go well, come out with another dime a month from now. Analysts, in other words, are more concerned about avoiding the big blunders than hitting earnings estimates on the nose. "Analysts are trying to maximize their long-run compensation," notes Richard Harjes, the director of research at Numeric Investors, which manages mutual funds based on earnings revision analysis. "And their overall reputation has as big an impact on their income as being accurate does. The worst thing an analyst could do is raise a number and then cut it." The 'cockroach theory' The upshot of all this: You can be pretty sure that positive revisions will be followed by more positive revisions. If you don't buy the psychological analysis, then consider this: Studies back it up. Once an estimate is revised in one direction, there is a greater than 50% chance the next change will be in the same direction, notes Ed Keon, director of quantitative research at Prudential Securities. Quick Reference What is a company's consensus EPS trend? What is Zacks research data? This concept is neatly summed up on Wall Street as the "cockroach theory." See one and there are lots more where that came from. This isn't always the case. The trick for you as an investor is to find companies where a dime really means a dollar over the course of a year. We'll go over how to do that in Part 2 of this series, which will appear Dec. 15. 2. Even if they understand the point just explained above, investors often do not fully price the implications of an upward estimate into the market immediately. There are a couple of reasons for this. "First, not everyone agrees with the information right away," explains Keon. "It takes a little while for the market to absorb the concept that the future will be different. Some people will want more evidence. But with the stock market, if you wait for something to be proven beyond a reasonable doubt, then it is too late. It is already reflected in the stock price." Despite the uncertainty holding investors back, you can be pretty sure that upward revisions will be followed by more of them, notes Keon, because once expectations start changing in one direction, they usually continue to change in that direction. Besides, notes Harjes, even if money managers are pretty sure that a revision foreshadows good news, they will naturally build up a position in the stock slowly, simply because that's how they do business. "They slice into a position gradually, just like the analysts do with the numbers," says Harjes. "Investors who want to put 1% of their portfolio into a stock will only go 20% of that in the first slice." Then they wait, and buy more if things still look good. Result: Revisions are not priced into the market right away.
Investment Finder Redwood Growth with Increased Estimates Find the growth stocks that analysts are expecting soaring earnings from with Investment Finder.	Try it yourself How can you put this to work for yourself as an investor? For one thing, in upcoming columns I will be featuring promising stocks with positive revisions, based on screens like the ones you can run in the Investment Finder, as well as interviews with buy- and sell-side analysts. Or, you can use the system yourself right away by adding Investment Finder criteria "Advisor FYI / Analyst Projections / Earnings Estimate Increased Since In the Past Quarter" to any screen you already use. For instance, if you add that criteria to the Redwood Growth screen of the SuperModels column, you reduce your buy list down from 15 stocks to just six: Qualcomm (QCOM, news, msgs), Circuit City (CC, news, msgs), Gateway (GTW, news, msgs), EMC Corp. (EMC, news, msgs), Home Depot (HD, news, msgs) and Paychex (PAYX, news, msgs). Next, mutual funds at firms such as Numeric Investors and Bogle Investment Management run portfolios based on the system, often with good results. Zacks Investment Research provides recommendations based on revisions, for a fee. Or you can hire a brokerage like Prudential, which uses revisions analysis extensively in its quantitative research. At the very least, put revisions on your list of things to check before buying a stock. "If the forecasts are dropping, you might be better off waiting until the fundamentals start to improve and that is reflected in the earnings revisions," says Keon. Most earnings 'surprises' engineered One earnings-related tool you don't need to spend as much time on: Earnings surprises. Once upon a time, surprises were a good sign. Like revisions, they forecasted more upward earnings revisions and made stocks jump.
Strategies Recent articles: • Get a clue from the insiders by Mike Robbins, 11/17/99 • Martha Stewart and WWF show great muscle by Tom Taulli, 11/3/99 • Wrap accounts -- cheap professional advice? by Randy Myers, 10/20/99 more...	But then CEO compensation became more closely linked to stock prices. Executives quickly caught on that they could increase their pay by manufacturing lots of "surprises" to move up their stock prices. Many of them got into the habit of managing down earnings expectations in the marketplace. Meanwhile, they used accounting gimmicks to squirrel away a few cents for when they needed to produce a surprise. Want proof? Not long ago, the ratio of positive to negative surprises for large-cap stocks was usually about 50/50. Last quarter, only 3% of them disappointed, while 30% produced positive surprises, notes Keon. "Earnings season is becoming as well-scripted as a professional wrestling match. It is still an interesting spectacle, but most of the surprises are engineered." All this means that surprises simply aren't as useful at predicting earnings revisions and the upward movement of stock prices. But the manipulation game is good news for short sellers. That's because companies that stretch to produce lots of little surprises sooner or later hit a point where they can't do it anymore. Then they turn in one big, fat disappointment, says John Bogle, of Bogle Investment Management. This game has created an opportunity for short sellers who are clever enough to figure out which companies are stretching the numbers. "Because," Bogle says, "when they collapse, they fall much further than they used to." Data providers MSN Money's editorial goal is to provide a forum for personal finance and investment ideas. Our articles, columns, message board posts and other features should not be construed as investment advice, nor does their appearance imply an endorsement by Microsoft of any specific security or trading strategy. An investor's best course of action must be based on individual circumstances. Copyright © 2009 Thomson Reuters. Click for Restrictions. Quotes supplied by Interactive Data Real-Time Services.