What are we looking for?
Companies with strong earnings surprises
The beginning of earnings season starts right after the end of the quarter and is very important for a number of reasons. This is the time for companies to report their quarterly results, which form the basis for analysts to revise their expectations. A lot of investment analysts will use the quarterly results to adjust their forecasts for the current year, which can have a significant impact on the price of a stock. For example, it’s not uncommon for shares to jump 20 per cent or more if a company significantly beats analysts’ expectations.
Today, I used Morningstar CPMS to look for companies of all sizes with strong momentum in their reported earnings per share and which have recently beat analysts’ expectations. The online platform uses a proprietary methodology for calculating the quarterly earnings surprise. It is adjusted in two ways: A decay factor is used to reduce the surprise as time passes; and earnings variability is factored into the calculation to ensure that if two companies beat the consensus estimate by the same percentage, the company with the lower earnings variability will have the higher earnings surprise. Morningstar CPMS also uses a proprietary methodology for adjusting the earnings per share of each company in the database to make sure the number has less management bias, making it more comparable over time and between companies.
In addition to good earnings numbers, we also used a screen to make sure analysts have a positive outlook for the company. In order to reduce volatility, I used the variability around five-year earnings per share to make sure these companies have more consistency in their reported income. Another low risk metric that I used is the 180-day standard deviation to reduce price volatility. A low standard deviation means the return for the stock hasn’t changed significantly from its 180-day average. The Morningstar Quantitative Financial Health Score was used to make sure these companies are in a good financial position. This is a proprietary variable that measures the probability that a firm will fall into financial distress. It uses a predictive model designed to anticipate when a company may default on its financial obligations.
The investment process started off with all 2,000 U.S. stocks in our CPMS database. Then we ranked our stocks from 1 to 2,000 according to the quarterly earnings surprise, quarterly earnings momentum, three-month earnings revision, variability around five-year earnings per share and the quarterly sales momentum.
Next, we applied four screens to create our list of stocks:
- three-month earnings revision over 6 per cent;
- 180-day standard deviation below 30 per cent;
- Morningstar Quantitative Financial Health Score above 0.6;
- Quarterly sales momentum above 0.
What we found
I used CPMS to back-test the strategy from January, 2006, to October, 2021. During this process, a maximum of 15 stocks were purchased and equally weighted. The portfolio is rebalanced monthly, and the strategy produced a return of 15 per cent since inception, whereas the S&P 500 Total Return Index returned 10.7 per cent. Today, the top 15 stocks that qualify for purchase into the strategy are listed in the accompanying table.
As always, investors are encouraged to conduct their own independent research before purchasing any of the investments listed here.
Phil Dabo, MFin, is a vice-president of business development at Morningstar Research Inc.
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