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 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.
This model is aggressive and can be leveraged. The recently completed analysis of third 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. Here on my site is a brief recording with a review of the third quarter numbers.
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 it aims for returns that are very high.
The month of November did not provide good opportunities to sell stocks, and with the Surprise model fully invested and leveraged, there was no room to add new buys. There were some disappointments in the third quarter financial statements and some positions need to be sold to restructure the portfolio for the next round of surprises to be announced in the first weeks of the New Year. The only sell decision I was able to execute was in response to the poor report at LSI Industries (LYTS) .
There are other sell decisions to be made as conditions allow this month. The portfolio is leveraged, as the large population of depressed share buy ideas in September made adding stocks irresistible. I am using the recent rally in stocks to reduce leverage and sell positions in companies that were not able to sustain the surprise pattern.
