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Posted 12/15/99
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Strategies 8 ways to tell what earnings revisions really mean Pay attention when analysts revise their estimates for a stock you want to trade. Here's how you can separate the meaningful indicators from the false signals. By Michael Brush Earnings revisions are a great tool for picking superior stocks. But putting them to work is a bit more complicated than simply finding companies whose revisions are headed up and buying them. To be sure, positive revisions can be a useful component of any stock screen. But to make revisions really work for you, you need to apply some of the basic rules used by the pros.
The problem, simply put, is that not all earnings revisions are created equal. Some are pretty strong signals that a stock is heading up, while others are fairly meaningless. A few simple steps go a long way toward weeding out the false signals. A few of the more-important methods require access to detailed revisions data offered by IBES International, for a fee. (Unfortunately, Zacks Investment Research -- provider of earnings revisions data to MSN MoneyCentral -- does not always provide the level of detail you need, and First Call does not offer a retail product.) But even if you don't have access to an advanced database, you will be able to apply many of the following concepts: 1. Positive earnings revisions mean less at companies in commodity sectors. Instead, you should get excited about upward revisions at companies that have some kind of "franchise." Forget about fast-food chains. A franchise means there is something special about a company's product or process, special enough so that customers are convinced that nobody does it better. The result: Those customers grudgingly will pay more when asked. And the franchise serves as a barrier to entry, protecting the company against competitors. "You want to look for companies that have differentiable products, companies that have more pricing power," explains John Bogle Jr. of Bogle Investment Management, a mutual fund and money management firm that uses earnings revisions analysis. "Look for companies that are price leaders, not price takers." Lots of software companies, for example, are price setters. Examples that are the subject of recent positive revisions include Computer Associates (CA, news, msgs) and Hyperion Solutions (HYSL, news, msgs). In contrast, disk-drive producers and many of the chip makers, such as Advanced Micro Devices (AMD, news, msgs) and Micron Technology (MU, news, msgs), are examples of price takers in commodity sectors. The problem with commodity groups is that even when strong revisions send off a good buy signal, the sector can turn on you easily if overcapacity develops or if price wars break out. Anyone holding the disk-drive stocks through the fall of 1997 knows what this means. The companies started cutting prices and stock prices plummeted. 2. Estimates have to be going up for the right reasons. Was the revision due to some one-time event like a tax change or refinancing at lower interest rates? Ho hum. As I point out in my book, "Lessons from the Front Line," you want to see upward revisions caused by some lasting change inside the company -- such as the development of a new technology or the successful defense of a patent in court -- that will fuel earnings growth for some time to come. Conexant Systems' (CNXT, news, msgs) development of software-based modem technology, called SmartDAA, should help the company maintain its strong position in the modem market, says Robertson Stephens analyst Arun Veerappan. | |||||
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Glossary Cash flow Market capitalization Price/earnings ratio Price/sales ratio Selling short Zacks average brokerage recommendation |
By the same token, you should not read too much into revisions sparked by an external event over which the company has little control. Earlier this year, for example, the meat packer IBP Inc. (IBP, news, msgs) got very strong upward revisions that landed it on some recommend lists that use the system. But the stock was erratic. No surprises here: The revisions were based on an increase in the price of pork. The company has little control over that, and pork prices can change from month to month. Portfolio managers also screen out numbers bumps caused by accounting gimmicks such as changes in write-offs or depreciation levels. One way to do this is to check whether upward revisions are backed by positive trends in cash flow. 3. Estimate revisions analysis tends to be more effective with smaller, less-covered companies. This occurs because information about these companies does not spread through the market as rapidly, notes Bogle. For example, small-cap software company Cognizant Technology Solutions (CTSH, news, msgs) was getting nice revisions throughout 1999. But the stock did not go ballistic until about six weeks ago. Another small-cap company that has been getting good revisions but has not moved quite so much is Best Software (BEST, news, msgs). But be careful about venturing too far down in the world of small stocks. Companies with a market capitalization below $250 million will be ignored by many fund managers, since it is hard for them to get a position without moving the price too much. With few potential buyers on your side, your microcap stock may not move even if it keeps turning out good news. Chuck Hill of First Call also points out that brokerage houses covering small-cap stocks are more likely to have investment banking connections with those companies. This does not necessarily taint their estimate revisions, but you have to be on your guard. 4. Revisions further out in the future are more significant. These tell you more about the long-term trends. A few weeks ago, for example, many retailers beat their estimates and got decent near-term numbers bumps. But for many of these stocks, the analysts are not raising their estimates as much for 2001. This is not a good sign. It probably reflects an expected downturn in consumer spending power. | |||||
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"If the average of all the estimates goes up because of analysts that come from the low end to the mean, it may be that a couple of guys finally got around to doing their homework. Big deal." -- Chuck Hill, First Call |
5. Pay close attention to what "the ax" is doing. Each stock has one or two analysts who do a better job than everyone else. Many money managers put more emphasis on what is going on with their estimates. "If analysts are covering 20 names, there is no way they can have good relations with all the companies," says Richard Harjes, the director of research at Numeric Investors, a company that manages mutual funds based on earnings revision analysis. "They won't have the same level of insight for each one. So they have an A-list of stocks they know very well. We figure out which analyst to overweight because they have been more accurate in the past, or because other analysts tend to follow what they say." You can understand who the ax is by tracking the accuracy of the analysts, or by looking at rankings from Institutional Investor and the Zacks All-Star Analyst Survey published once a year. Also, watch for the one who moves markets whenever he or she comments on the stock. 6. Highs going higher are more important than lows playing catch-up. "If the average of all the estimates goes up because of analysts that come from the low end to the mean, it may be that a couple of guys finally got around to doing their homework," explains Hill. "Big deal." Much better to see analysts who are above the mean go even higher. "Now we are talking. The mean might have gone up by the same percentage as in the first scenario, but it is more meaningful." The same holds true for lows going lower, if you are looking for stocks to short. Likewise, money managers like to see a new high (or a new low for short candidates), notes Joe Abbott, the chief equity strategist at IBES International. Analysts also want to see trends in estimates over time, as opposed to estimates that move up, and then just sit there for months. "It is a continuum," says Ben Zacks of Zacks Investment Research. "It is not an absolute event." | |||||
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Strategies Recent articles: • Track the 'numbers bumps' for stock jumps by Michael Brush, 12/1/99 • 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 more... |
7. Determine whether strong revisions have already been built into the price. "If a stock has just run up 60% and the analysts are raising estimates another nickel, isn't that already in the price?" asks Zacks. Probably so. Right now, for example, many of the fiber-optic-related companies profiting from the expansion of Internet capacity, such as JDS Uniphase (JDSU, news, msgs), have been on a tear. Sure, they have gotten great revisions, but at some point the market will decide they just can't take on higher valuations. One way to deal with these cases is to wait for the stocks to pull in before you buy. At the very least, you should combine some value measure -- such as historical price-to-earnings or price-to-sales ratios -- with earnings revision analysis to flag the high fliers. 8. You still need to look at the fundamentals. One problem with any quantitative system is that, if it works, it can make you lazy. Money managers who use revisions analysis successfully also spend lots of time looking at financials, business plans and sector trends. Says Harjes: "You can model black-and-white things like financial ratios. But it also takes a lot of human judgment about things like the quality of management." In other words, the revisions numbers may provide a shortcut to help you isolate a limited group of great candidates in the market, but you still have to do your homework on each before you lay your money on the line. Starting Jan. 7, look for a column every other week by Michael Brush about specific stocks that meet his earnings revisions screens.
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