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A simple trend with a high win rate for investors

Steve Clapham illustrates how to understand earnings estimates and use them to your advantage
A simple trend with a high win rate for investors

I prefer to buy stocks when profit forecasts are increasing. When I was an analyst at large hedge funds, one of the main checks I made to see whether an idea was worth pursuing was to look at the trend in earnings estimates.

If estimates are falling, I need to be comfortable that the trend is about to reverse, if I am considering a long position. Share prices usually follow estimate revisions, so if a share price has been rising and the estimates have been falling, that would be an unusual signal and perhaps worth investigating.

But most of the time, we see shares go up when the consensus of analysts’ forecasts rise. This consensus is simply the average of the estimates of the analysts following the stock. This is often one of the most important parameters followed by fund managers and it’s something that companies’ investor relations departments also track closely. It’s worth understanding how it’s constructed and used.

 

The story behind the number

The most important number is always the earnings per share (EPS) number for the current year. Although the trend in this parameter is the critical variable, I also always consider three input factors:

  • Number of estimates used to construct the consensus
  • The range around the consensus
  • The distribution or dispersion of estimates

The consensus is considered more reliable when there are multiple analysts following a stock. Are there enough analysts producing forecasts to generate a reliable consensus? For a small company, with just three analysts, the consensus can jump when one of the analysts changes his or her forecast. Ten should be enough for a larger stock for the consensus to be meaningful. For the biggest companies, such as Vodafone (VOD) and HSBC (HSBA), there can often be as many as 40 analysts, which creates its own issues.

The range around the consensus is significant. Consensus for a company with a wider range of estimates is usually less reliable than one with a smaller range. This obviously is dependent on the sector, as there is a wide variability in ability to forecast. Utilities are simpler, commodity companies are more challenging, as are stocks such as transport companies with potentially high variability in profitability. The range in forecasts is therefore often a clue as to the quality of the business.

The distribution or dispersion of estimates is another factor to be careful of. When looking at a company with 40 forecasts the range can often be widened by one or two outliers which distort the result. The problem is that you cannot dismiss the outliers – they may be right.

One of my specialities when I was a sellside analyst was in having the most extreme forecast for a stock – I would predict a wildly better or worse result than the consensus, accompanied by a strong buy or sell recommendation, and investors would then feel the need to understand my arguments.

One helpful datapoint is the date of the forecast – on Bloomberg, it’s very easy to rank the forecasts by date and therefore see if there is an outlier at the low end of the range simply because it’s an old forecast that the broker has failed to update (when an analyst leaves, the forecast can remain in the system and of course it will not be updated until (s)he is replaced).

Some gaming goes on. An analyst with a bullish opinion on a stock may deliberately have lowball forecasts in order to be wildly bullish when the company reports earnings above their forecast. They can raise forecasts for the following year, reinforcing their positive stance.

An illustration may bring all this to life. Consider Ash, a company in the construction sector – the consensus was $1.96 per share, because one of the analysts following the company, Charlie, had been a bit too optimistic in his numbers:

 

AnalystBrokerASH EPS 21
AndrewRobber, Thief and Charlatan1.81
BertieCautious, Circumspect and Careful1.86
CharlieMoney, Grabbers & Co2.22
Consensus estimate1.96


The company IR Department were a little concerned and called up Charlie to point out that his spreadsheet didn’t add up, leading to Charlie revising his forecast, and the consensus dropped like a stone:

 

AnalystBrokerASH EPS 21
AndrewRobber, Thief and Charlatan1.81
BertieCautious, Circumspect and Careful1.86
CharlieMoney, Grabbers & Co1.85
Consensus Estimate1.84

 

The example is a bit exaggerated, but this does happen in real life and this is why you need to look not just at the consensus but also the range. The spread of those estimates can indicate that the consensus is not very reliable. In our examples above, let’s say there were 10 analysts in total covering the stock – the range of 1.81-2.22 would be pretty wide and the 1.81-1.85 would be very narrow. The range depends on the number of analysts, quality of analyst and particularly on the sector, as mentioned earlier.

 

The trend is your friend

But the most important variable for investors is the trend in the consensus number, and it’s this parameter that professional investors track closely. The chart shows the trend for Ashtead (AHT), the equipment hire company that seems well-placed to capitalise on the projected increase in US infrastructure spending.

 

Source: Behind the Balance Sheet from Sentieo data

 

The chart shows the trend in the 12 months forward estimate, obviously impacted by the pandemic but showing good growth thereafter. We can superimpose the stock chart on the estimate revisions, as we can see in the chart below; this is useful as it helps to illustrate how much of the share price performance may be attributable to the improved earnings prospects, and how much to a rerating.

 

 

I like to look at this chart, generally on an 18-month view, to see at what point the stock market anticipates the recovery and to what degree earnings expectations drive the price. The chart clearly shows the lead time before the estimates start to rise. The share price bottomed in the third week of March. It took until mid-June before there was the first tick up in estimates, just 4 per cent. It wasn’t until September that there was another increase, this time 8 per cent. And it was not until December that the estimates had really started to improve. By this time the stock had increased to £33, or 25 per cent up from the first tick up and 150 per cent up from the lows.

At that point, you might well have concluded that the fun was all over. Yet this stock went on to increase by another 65 per cent. To put this into context, the forward 12-month estimates have risen by 25 per cent.

Ashtead has therefore undergone something of a rerating, with the stock benefiting both from a reappraisal of immediate earnings prospects and an improving longer-term outlook, with investors prepared to pay up for participation. This colour on the share price performance is an invaluable output from the process of tracking estimate revisions – understanding where the stock has come from is an important element of understanding where it might be likely to go next.

And you don’t need to do a lot of work around this. I have introduced the concepts of the range and distribution of estimates around the consensus, but these are nice-to-haves, rather than must-haves. For most private investors, simply looking for stocks that have gone up on the back of rising estimates is a generally helpful strategy – and most important, it has a higher win rate than looking for bombed-out bargains. Yes, it’s a form of momentum strategy, but the use of the estimates trend introduces an effective fundamental input. It’s a research tool I could not manage without.

 

Stephen Clapham is founder of Behind the Balance Sheet and author of The Smart Money Method: How to pick stocks like a hedge fund pro.