Author: Bob Gay, GEARS
Covestor model: Earnings Surprise
Disclosure: Long MSA, UTEK, SWC, CMI, ATU, LUFK, CWEI, DVN, DO, PTEN, CNX, ANSS, FEIC, ADTN, AXE, MSI, CCO, IPI, SD
I created the Earnings Surprise Model to exploit the earnings surprise pattern in fundamental data. The components of the surprise pattern are rising sales growth, higher gross profit margins, high and falling SG&A expenses, lower financing costs and positive and rising cash flow returns. This pattern repeats itself frequently, not only across companies but also within the company record as economic cycles and product cycles affect growth.
The Surprise pattern measures an accelerating company. This accelerating phase of the company growth cycle is when the company produces a series of positive earnings surprises and often when the shares produce superior returns.
Depressed share price is also an important component of the Earnings Surprise Model strategy. The Surprise pattern is not a predictor of the future, but rather a measure of the current evident trend. That trend can reverse even in the short term and the depressed share price discipline helps limit the downside risk.
The Surprise model was hedged and underinvested as we entered the month of August, and the broad correction and larger group of surprise patterns created a longer list of buys. August was also a month of new numbers, as American companies reported their financial statements for the fiscal quarters ended June and July. Generally, the numbers looked good and the population of improving companies remains high. Here is a brief recording of mine (http://www.the-gears.com/wmv_files/igetwmv.aspx?wmv=review2011-2) with a review of the second quarter numbers.
The large correction in August increased the population of depressed share prices and created buy opportunities for companies showing the Surprise pattern.
New buys executed in August were Mine Safety Appliances Co (MSA), Ultratech Stepper Inc (UTEK), Stillwater Mining Co (SWC), Cummins Engine (CMI), Actuant Corp (ATU), Lufkin Industries Inc (LUFK), Clayton Williams Energy Inc (CWEI), Devon Energy Corporation (DVN), Diamond Offshore Drilling (DO), Patterson Uti Energy Inc (PTEN), Consol Energy Inc (CNX), Ansys Inc,(ANSS), FEI Co (FEIC), Adtran Inc (ADTN), Anixter International Inc (AXE), Motorola Solutions Inc (MSI), Clear Channel Outdoor (CCO), Intrepid Potash (IPI) and Sandridge Energy (SD).
This spring, while the population of depressed share was very low and surprise pattern opportunities were few, I executed a hedge strategy using puts. The strategy could not be implemented into follower (client) Covestor portfolios. I have closed this strategy out, and I will be cautious in the future to only execute strategies that can be replicated.
The Earnings Surprise model is now leveraged long (as of 9/1/11).
To create a successful stock portfolio requires attention, consistency and discipline. Most of all, it requires an information edge. Years of research have shown that shares of companies that are profitable with rising shareholder wealth perform better.
