Author: Bob Gay, GEARS
Covestor model: Earnings Surprise
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 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.
In an unusually weak stock market, the returns of the Surprise model can be very volatile. The model buys out-of-favor stocks and even with evidence of improvements in fundamentals, depressed shares can go from low to lower. That was our experience at the end of September when our Earnings Surprise model performed very badly in the weak end of the month. Highly volatile stocks in the model, plus leverage that was deployed in early September, hit the model hard. October produced a sharp rebound, lifting the portfolio value to a new high and recovering all the value lost since the peak earlier this year.
This model is aggressive and can be leveraged. The analysis of second quarter financial statements suggested that the recovery leadership was shifting from consumer durables spending to capital goods spending. There was no evidence of an overall peak in fundamentals. Still, the combination of increased perceived risk of stocks and fears of a slowdown in growth took share prices and bond yields to new lows in September. Here is a brief recording I made with a review of the second quarter numbers.
The third quarter financial statements that we have collected so far support our contention that despite all the concern about macro-economic weakness, companies continue to accelerate. With financial conditions improved, companies are beginning to increase capital expenditures. We have seen this cyclical pattern before from U.S. companies and using history as a guide, the next few years should bring strong corporate growth, higher commodity prices, higher inflation and rising interest rates. Assuming the capital goods driven cyclical advance unfolds as it has in the past, the peak will be evident in early 2013. We expect stocks will be 30% higher and long bonds will be 20% lower. Of the major asset classes, only stocks will produce an acceptable return in the late cycle scenario.
Fortunately we do not have to make decisions on such blind faith. In the next few weeks all public companies will deliver financial statements for the third quarter and we will have a clearer picture of the path of corporate growth. Over 50 years of data experience shows that we should be able to observe the peak in corporate growth when it appears. Sales growth will fall, costs will rise and inventories will increase.
For now we are in the acceleration stage of the corporate growth cycle. Even after the October rally, shares are still depressed and we believe investors should be increasing exposure to stocks and reducing investments in fixed income securities.
The Earnings Surprise model is designed to exploit the performance benefit of investing in leveraged and accelerating companies and to keep the portfolio strictly exposed to companies showing a surprise pattern in their fundamentals. The return stream will be volatile and transactions will be frequent, but we aim for returns to be very high.
