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5 ways to profit from earnings revisions
Changing earnings estimates can offer major signals about a stocks direction. Heres how to figure out if the signs point to profits.
By Michael Brush
Last week, we told you that one of the money machines of stock selection from the last decade is back up and running.
This system tracks positive changes by Wall Street analysts in earnings estimates for companies. These upgrades tend to pick up on improvements in business trends and lead to price gains for stocks.
But you cant just buy any stock with upward earnings-estimate revisions. Instead, you have to take care to screen out the false signals and must tweak the system in other ways to get more bang for your efforts. Here are five rules for getting the most out of earnings-estimate revision data.
1. Focus on small companies
The reasoning here is simple. Bigger companies have more analysts. So there are more watchdogs reporting news to more investors as developments unfold. Stock prices move quickly in response. By contrast, developments at smaller companies with fewer analysts take more time to move a stock price. This flies in the face of academic orthodoxy that wrongly concludes that stock markets are "efficient" -- that everything there is to know about a stock is reflected in its stock price.
Take a look at j2 Global Communications (JCOM, news, msgs). With a market cap of $581 million, the company got big upward earnings estimate revisions on June 20 when news spread that it was increasing prices for its mobile faxing service. By July 11, over three weeks, the stock had arced up 20% to reach $53 from $44 when the estimates first went up. The Nasdaq Composite Index ($COMPX) advanced just 4% over the same timeframe.
Estimate revisions seem to work best for stocks of companies in the $200 million-to-$2 billion market-cap range. But theyre also quite effective in the micro-cap arena, defined as anything under $200 million. These are stocks often shunned by investors because they are thought to be too small ever to attract serious buyers.
TASER International (TASR, news, msgs), which makes stun guns, popped up on my earnings-estimate revision screens in early May in the $7 range. Within less than two months, the stock was trading above $12 on news the Transportation Security Administration said pilots can pack stun guns to use against hijackers.
A study done by Eric Newman of the Richmond, Va., hedge fund TFS Capital shows how well estimate revisions work with small-cap names -- especially when you exclude those with high valuations. He screened the Zacks database for three criteria:
- Market cap under $1 billion
- Trailing price-to-earnings ratios of less than 20
- Five-year historic earnings growth above 15%.
Holding each basket of stocks that came up for just a week produced returns of 47% last year, and 34% this year, as of July 3. (To be sure, these are theoretical returns because they exclude trading costs on the 20 or so names that come up each week, and it would have been difficult for a money manager with holdings of any size to buy or sell many of these smaller names without moving the price.)
Companies with market caps of between $500 million and $2 billion with excellent earnings estimate revisions right now include:
- Galen Holdings (GALN, news, msgs), a pharmaceutical maker.
- Martek Biosciences (MATK, news, msgs), which sells nutritional supplements.
- Accredited Home Lenders (LEND, news, msgs), which concentrates on sub-prime mortgage lending.
- NII Holdings (NIHD, news, msgs), formerly Nextel International, a Latin American wireless communications provider.
- OMI (OMM, news, msgs), the crude oil shipping company.
- Penn National Gaming (PENN, news, msgs), operator of casinos and racetracks.
- Flagstar Bancorp (FBC, news, msgs), a Michigan savings bank company.
Three micro-caps with excellent estimate revisions include:
- Docucorp International (DOCC, news, msgs), which sells software used to produce customer statements in insurance and elsewhere.
- Advanced Power Technology (APTI, news, msgs), which makes chips used to regulate power in equipment used in areas like defense, avionics and medicine.
- Nu Horizons Electronics (NUHC, news, msgs), provider of electronics assembly and distribution.
2. Look for an 'outlier' analyst
Whenever you see one analyst with annual earnings estimates way ahead of the pack, thats an encouraging sign. The reason is straightforward. On Wall Street -- as elsewhere in life -- it is easier to explain why you made a mistake when everyone else made the same error. Instead, by going out on a limb and posting estimates way above the pack, analysts are putting their reputations on the line to some degree. It suggests they are pretty confident in their estimates -- and the other analysts may soon be playing catch-up, driving up the consensus estimate and the stock price as well.
For example, that stellar performer over the past three weeks -- j2 Global Communications had a bold outlier in Pacific Growth Equities analyst Joe Noel, who upped next years estimates to $2.90 on June 20. The other three analysts covering the stock bumped up their numbers to just $2.60.
Other stocks with good numbers bumps and a strong outlying analyst forecast include priceline.com (PCLND, news, msgs). An analyst at Thomas Wiesel Partners has posted estimates for this years earnings of 52 cents per share vs. an average of around 28 cents for the other three analysts covering the stock. Pacific Growths Noel is considerably ahead of the pack of analysts covering UTStarcom (UTSI, news, msgs), with estimates of $2.25 for next year compared to an average of $1.87. UTStarcom sells wireless equipment in China and Latin America, among other regions.
Friedman, Billings Ramsey analyst Michael Hoffman posted estimates for next year for CompuDyne (CDCY, news, msgs) of $1.22 vs. an estimate of 63 cents by the one other analyst covering the stock. CompuDyne makes blast-proof windows and doors used in the White House, other government buildings and also in private industry, as well as locking mechanisms used in prisons and software used in 911 call-tracking systems. Hoffman says he has greater confidence that a backlog of orders from government agencies will convert into real sales.
3. Exclude revisions done for the wrong reasons
Its important to go with companies whose estimates are going up for the reasons that suggest a sustainable growth trend. If estimates go up simply because the company makes a one-time accounting or tax adjustment, or because it refinances its debt, thats not very exciting. Likewise, cost cutting -- because it is probably not a sustainable source of improving earnings -- also should be discounted.
For example, Lightbridge (LTBG, news, msgs), which processes about 35% of cell phone service activations, has seen estimates double since June 19. But the improvement is primarily due to the company's announced plan to cut about 70 employees, for annual cost savings of $7 million or more. Tellingly, despite the massive increase in estimates, Baird analyst Sara Litton has a "hold" on the stock because of concerns about revenue growth.
Other head fakes abound. A company may have good earnings-estimate revisions, but if theres a plan in place for a buyout of the company, the stock price wont be moving much. Thats the case with Acres Gaming (AGAM, news, msgs). It has excellent earnings-estimate revisions, but its stock price looks like its stuck in amber because theres a proposal by International Game Tech (IGT, news, msgs) to purchase the company at a set price.
4. Seek pricing power and barriers to entry
Be cautious with companies getting good upward earnings estimates if they work in so-called commodity sectors -- meaning they produce things like very basic computer chips, computer hard drives or pork. These companies have little control over pricing -- which can fall sharply if a competitor builds too much capacity or cuts prices to win business, or if demand suddenly shifts.
Id carve out an exception right now for companies that produce natural gas because there are growing shortages in the United States, and it is hard to import. So powerful upward estimate revisions at companies like Clayton Williams Energy (CWEI, news, msgs) or Stone Energy (SGY, news, msgs) could signal further stock price advances for those stocks. All bets are off for those stocks if we get unusually cool summer weather, a warm winter, or an economic turn for the worse that cuts into demand.
Though there are exceptions like these, for the most part, you have to look for upward estimate revisions at companies that have sustainable pricing power or barriers to entry around their product. Some insurance companies enjoy some precious pricing power these days. Those with solid upward earnings estimate revisions include:
An example of a company with good estimate revisions and barriers to entry is Qlogic (QLGC, news, msgs), which makes storage system components and software special enough that it has an edge in that market. Another is UCBH Holdings (UCBH, news, msgs), the parent of United California Bank, which enjoys strong loyalties within its Asian customer base.
5. Take quality of earnings into account
Despite all the hoopla about crooked accountants and bogus earnings in the past three years, you can be sure that many companies will continue to cook the books, or push the limits of accounting guidelines to make their earnings look better.
This practice is particularly common among companies with good earnings momentum, or ever-increasing rates of upward numbers bumps. At some point, business growth begins to slow, so management is tempted to turn to accounting tricks to keep the reported numbers ablaze. Its crucial to weed out these jokers when using earnings estimate revisions because as momentum plays out, they cause lots of damage when they blow up.
Analysts turn to the usual suspects for signs that books might be getting cooked, including:
- Accounts receivables rising faster than sales. The comparison should be to the same quarter in the prior year. Accounts receivable measures the amount of outstanding bills a company has to collect. A buildup here signals that a company is booking revenue aggressively, or relaxing credit standards to meet their earnings numbers.
- Rising inventories vs. sales. This shows that business is weak, and an earnings-busting write-down of inventory may be on the way. A third warning sign is a decline in free cash flow, or the hard cash left after you strip out accounting adjustments like depreciation and amortization.
Unfortunately, individual investors find it hard to pick up these warning signs without a lot of tedious analysis. There are no free databases out on the Internet yet.
To come up with a short list of stocks with good estimate revisions and higher quality earnings, we turned to Prudential Equity Groups Steven DeSanctis, who uses both factors in screening for stocks for clients. Stocks ranking high on both counts include: the retailers Coldwater Creek (CWTR, news, msgs) and Goody's Family Clothing (GDYS, news, msgs); the health insurer Mid Atlantic Medical Services (MME, news, msgs); the telephone company Talk America (TALK, news, msgs); quality control equipment producer Verisity (VRST, news, msgs); religious book publisher Thomas Nelson (TNM, news, msgs); and broadband provider UnitedGlobalCom (UCOMA, news, msgs).
Where to find the data
Fortunately for individual investors, you can find a lot of earnings-revision data for free on the Internet.
For starters, of course, there's this site, MSN Money, where you can see the baseline trends in earnings estimates by entering a ticker in the stock box on the homepage and then clicking on "earnings estimates" or "consensus EPS trend." MSN Money's Deluxe Screener lets you screen for the companies with the best earnings estimate revisions -- among hundreds of other important factors.
Meantime, MSN Money's StockScouter tool uses earnings estimates, along with several other factors, to rank stocks. StockScouter has been proven useful in achieving above-market gains.
Investors seeking even more earnings details may consider visiting earnings-data provider Zacks Investment Research at my.zacks.com. (See link at left under Related Sites.) For starters, click on portfolios and then Zacks #1 Rank to find a list of companies recently getting upward estimate revisions. Drill down a bit further by clicking on the ticker, and youll see a complete array of estimates posted by the analysts following that stock; this is the only place youll get this information for free on the Internet. This is useful because it allows you to check for an outlier, or to see if there are recent cuts in the numbers by a few analysts even if the overall consensus is up (a red flag). You can also do some screening at this site to find companies with the biggest changes in estimates.
At Reuters Multex Investor, you can call up reports that give you a sense of the trends in estimate revisions for a company. (See link at left under Related sites.) But you cant see individual analysts estimates to look for an outlier, and you cant do screening unless you pay for a higher level of service. Free screening, however, is on the way, says the company.
At Thomson Financials Earnings Center, found under research and tools on the Thomson Financial site (See link at left under Related sites.), you can rank stocks by percentage changes in estimates and call up reports on individual stocks that allow you to see recent estimate revisions trends. Again, though, you cant see a list of individual analysts to look for outliers.
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