Quant Concepts: A Strategy for Earnings Surprises

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Phil Dabo: Welcome to Quant Concepts. Now that most companies have finally reported earnings for the second quarter, we can assess how well they've performed. A lot of investors were keeping a close eye on second-quarter earnings to see if there'd be an indication that the U.S. was falling into a recession. We found that 75% of the companies in the S&P 500 that reported earnings since the beginning of July had beaten analyst expectations. Corporate earnings have been stronger than expected, with 65% of companies recently reporting positive earnings compared to 65% of companies reporting negative quarterly earnings growth during the 2020 recession.

Today, let's take a look at a strategy that focuses on companies with good earnings momentum, that have beaten analyst expectations. As always, let's start by ranking our universe of stocks, which includes all of the companies in our U.S. database. Next, we're going to rank our stocks according to six key factors. The first factor is a quarterly earnings surprise because we would like to see companies that have beaten analyst expectations. The next factor is the three-month earnings revision because we would like to find companies that analysts are positively increasing their expectations for.

Next is our quarterly earnings momentum because we would like to find companies that have been growing their bottom line and I also use the quarterly sales momentum to capture top-line growth. The earnings variability around five-year earnings per share focuses on companies that are more consistent with that bottom line number. And lastly, I use the three-month relative strength of the stock to find companies that are outperforming the market.

Now that we have our stocks ranked from 1 to 2,000, we're going to go through our buy and sell rules, starting with our buys. We're only going to buy stocks that are ranked in the top 30th percentile, and we're only going to buy stocks that are ranked in the top third, based on three-month earnings revision. We want to reduce the amount of volatility in the portfolio by excluding stocks that are not in the bottom third on the 180-day standard deviation. We've used the Morningstar quantitative financial health score to assess if a company is in good financial health and determine the likelihood that it will fall into financial distress. Here we want companies to be ranked in the top third. Our last buy rule is for companies to have a quarterly sales momentum that ranks in the top third of our list.

Now let's take a look at our sell rules, which are a bit different today because we're not going to sell stocks based on their overall ranking. As you can see at the top of the screen, we're okay with all stocks within the top 100th percentile. However, we're going to sell stocks if their earnings revisions deteriorate and become negative, falling to the bottom of our list. We're also going to sell stocks if they become too volatile and fall to the bottom of the list based on the 180-day standard deviation. Our last two sell rules will eliminate stocks if their financial health deteriorates and falls to the bottom third of our list and if their quarterly sales momentum drops out of the top third of our list.

Now let's take a look at performance. The benchmark that we used is the S&P 500 Total Return Index, and we tested the strategy from January 2006 to July of 2022. Over this time period, the strategy has generated a very strong 15.1% return, which is 5.6% higher than the benchmark, with a 90% annualized turnover. We can see by looking at the annualized returns that this strategy has outperformed the index over every significant time period, and it's done so with lower price risk, as you can see by the standard deviation, which has contributed very well to strong risk-adjusted returns, as you can see by the Sharpe ratio. The strategy also has lower market risk, as you can see by beta.

When looking at this performance chart, we can see very good outperformance over time. When looking at the up and downside capture ratios, we can see very strong performance in up markets with very good downside protection in down markets, which has resulted in a very strong overall market capture ratio, showing that this is a strategy. That has performed well throughout many different market cycles.

This is a great strategy to consider if you're interested in companies that have positive earnings momentum, tied with positive analyst expectations and the ability to beat those expectations on a quarterly basis. The strategy has performed very well over the past 10 calendar years, having only lost to the benchmark 30% of the time. You can find the buy list along with a transcript of this video.

From Morningstar, I'm Phil Dabo.

Find the buy list here.