Watching the Estimate, Revision Trends

 | Jun 17, 2013 | 10:00 AM EDT  | Comments
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My recent posts have emphasized the need for the consensus estimates to be rising in order for me 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 you, the investor, anything for simply riding the coattails of the market's research effort. 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 to detect 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, etc.), 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 that had big estimate changes had big performance (either up or down), but this guides you to the best names to start 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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