I am spending most of my morning trying to ignore all the hype and chatter surrounding a certain Chinese internet company that is making its NYSE debut this morning. I have no interest in said company, even less so as it is a Chinese company.
I could go on an epic rant about U.S. investors funding a company under the thumb of a government that despises us and all we stand for as well as my natural distrust and disbelief of any number issued by a Chinese company. But I will resist the urge. I won't even cite the horrific corporate governance issues as valuation expert Professor Aswath Damodaran pointed out earlier this week. Damodaran told CNBC, "I'm not getting a piece of a company. I'm getting a piece of a shell that owns a company where a politburo, basically, sets the board of directors."
Instead of obsessing on this company, I will keep my head down and continue fooling around with the new screening and back-testing toy I downloaded Thursday.
I had a discussion with some friends about the possibility of pairing deep value stocks with positive earnings surprises. One of the hardest things about value investing is that it can often be difficult to find a near-term catalyst. And you can hold stocks that go sideways, or even down, before beginning to rise to somewhere near fair value. On the idea of using earning surprise as a catalyst, I turned to the earning surprise experts at Zacks. Once I started researching the idea, I found that they had a free trial of their screener and back-testing tool and I have been like a kid at Christmas since playing around with it.
I ran a test of the idea of using the two factors together, and over the past few years it has worked well. Unfortunately, one can only test back to Sept. 2, 2011 with the tool. But the return from buying stocks that trade below book value and post a positive earnings surprise of 25% or more has been pretty good. The stock market has been strong in the test period with the S&P 500 gaining 22% on an annualized basis. But our cheap surprise strategy has done even better, averaging an annual gain of 29.7%.
When I ran the screen for stocks that are currently trading below book value that posted an earnings surprise, I unexpectedly found that many of the dirty companies I like are on it. To hear the experts talk, oil drillers and miners are disappointing and on the verge of extinction.
The analysts may be a little too pessimistic. Cliffs Natural Resources (CLF), Allied Nevada Gold (ANV) and Harvest Natural Resources (HNR) all exceeded the estimates in the past quarter by 25% or more. Some of my favorite offshore drillers including Rowan (RDC), Noble (NE) and Transocean (RIG) all trade well below book value and reported results that exceeded expectations.
Most of my little community banks do not have a lot of analyst coverage as Wall Street tends not to care too much about stocks with low trading volumes and small market caps. Those that do have coverage, however, have been doing better than the few people following them expected this year. Eagle Bancorp (EBMT), Malvern Federal (MLVF), HopFed Bancorp (HFBC) and Laporte Bancshares (LPSB) are all cheap little bank stocks that exceeded the expectations of the limited analysts following them.
Shipping stocks have been all over the place this year as the volatile group responds to every twitch in the global economy, crude oil prices and Baltic Dry Index. Many of them are actually doing much better than anticipated and the stocks are still cheap on an asset basis. Dryships (DRYS), Tsakos Energy Navigation (TNP), Nordic American Tankers (NAT),and Navios Maritime (NM) all earned at least 25% more than analysts expected last quarter.
Most of what I write from day to day is geared toward long-term investors and the idea of combining earnings surprise and price to book value is certainly a valuable concept for this group.
Traders should sit up, however, and take note of this idea as well. The back test used a monthly rebalancing so once a stock traded above book value it was kicked from the portfolio. There was a 25% turnover rate each month for this portfolio. This is probably the perfect list of candidates to apply your statistics and patterns in search of trading profits.
As John Templeton once pointed out if you do what everyone else does you cannot outperform everyone. Using a list of stocks with a strong bias to the upside and far less competition from other traders is probably going to dramatically improve your results. Cheap stocks with a strong catalyst form an earnings surprise should work well for investors and traders alike
