Stunning Predictive Power

 | Jan 07, 2013 | 9:30 AM EST
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As longtime readers will know, I advocate looking at changes to earnings-per-share estimates as a way to sniff out what are probably the best-performing stocks. So did this strategy work in 2012? Let's look at the evidence.

First, we take a look at the 20 top-performing and the 20 bottom-performing stocks in the S&P 500. (We'll limit this analysis to the S&P 500 for simplicity, but the analysis applies to broader universes, as well.) The top 20 stocks had an average return of 93.55%, ranging from 188% at Pulte (PHM) to 66% at Trip Advisor (TRIP). Over the course of the year, the average change in the EPS estimate for 2012 was a 38.56% increase. Of the 20 names, only five had estimates lowered during the year.

Among the bottom 20, the average return was minus 32%, ranging from a negative 18% to down 61%. The average change in 2012 EPS estimate was down 61.4%, and every name but one had a negative revision over the course of the year. So it's clear that, for the top and bottom rungs, the estimate changes are highly indicative of likely stock performance.

Top/Bottom 20 in Stock Performance vs. Estimate Changes
Source: FactSet, using Thomson Reuters Estimates

Is the trend applicable to the full list? For the full S&P 500, I divided the group into quintile groups based on stock performance. In other words, the top 100 names are quintile 1, the next 100 names are quintile 2 and so on. The table below summarizes the results.

2012 Stock Performance vs. Estimate Change

Looking at the groups, better stock performance saw similar trajectories in EPS estimates. Stock performance and estimate revisions are highly correlated.

Now, of course they are not perfectly correlated. Some names performed well even with a downtrend in earnings, and vice versa. But, as I often say, if you want to catch fish, go where they are biting. Names with upward-EPS estimate trends are more likely than not to deliver better stock performance. The challenge for you as an investor is to find the names that will see the best upward revisions going forward. It's easier said than done -- but you will earn your returns if you sniff them out correctly.

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