Why Estimate Trends Matter

 | Jun 16, 2013 | 6:00 PM EDT
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My recent posts have emphasized that I need rising consensus estimates in order to be enthusiastic about either the market or individual stocks. Last week I noted how Apple's (AAPL) stock-price action has mirrored the reductions in its 2013 earnings-per-share estimate. A couple days before that, I reiterated my caution on the market as a whole due to the lack of upward revisions in the S&P 500 operating-earnings estimate. A few readers have emailed to ask why I care so much about revision trends, so now seems like a good time to explain. 

The estimate trend, per se, is not really what we are trying to discern. Rather, the revision trend is one proxy for what all investors are seeking: a mismatch between the expected earnings performance and what actually happens. (There are other proxies as well, the most famous being valuation. Low valuations usually equal low expectations.) If a company grows earnings at exactly the rate expected by the market, the stock should offer no more than a market return. Mr. Market will not pay anything to you, the investor, for simply riding the coattails of the market's research effort. In order to get paid, your work needs to uncover incorrect expectations -- and implicitly correct them. 

There are troves of data that show the estimate trend is a good proxy for detecting situations of incorrect expectations. Here is but one example. The table shows the S&P 500 divided into decile groups (the top 50 names, next 50 names and so on) based on the change in the 2012 EPS estimate over the course of the year. For all but the worst group, the biggest upward revision corresponded with the best stock performance, on average.  

This does not mean every stock with big estimate changes also saw big performance shifts, whether up or down. However, this will guide you to the best names for starting your research effort.

Similarly, the relationship is holding so far in 2013. The better stock performance is corresponding with better estimate trends. 

As I regularly note, the estimate trend is a starting point. Other elements matter, too, such as valuation and your fundamental analysis. Nonetheless, when analysts are detecting improving fundamentals, and are revising their earnings estimates accordingly, I sit up and take notice as well.

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