- The recent short-term trend whereby stock prices have not initially responded as favorably to earnings surprises is likely temporary. If a company’s share price doesn’t react to a positive earnings surprise and good guidance, that could be an indication that the stock is underappreciated and undervalued.
- However, earnings surprises do still matter. They provide valuable information, even if it isn’t immediately recognized. As we show below, companies that report positive earnings surprises have historically performed better than those that have not.
- We believe that a stock’s reaction to repeated earnings surprises over a multiyear period is more important than its reaction over a few day period before/after each announcement. A positive earnings surprise, especially accompanied by improved guidance, has often been an indication of improving fundamentals and has frequently lead to consecutive earnings beats and positive price momentum.
One of the most welcome surprises in the world of investing is the earnings surprise. Companies that beat expectations have historically been rewarded with an immediate bump up in their stock prices. The size of that bump varies, but for nearly 10 years (since the fourth quarter of 2008), the stock prices of S&P 500 Index companies with positive earnings surprises gained 1.24% on average during the four-day window surrounding their earnings announcements (per FactSet Research). However, recent history shows those bumps in price are now shrinking in size. As noted in the following chart, the first quarter of 2018 saw an average positive earnings surprise price appreciation of only 0.15% on average during the same four-day window. It was the fifth-straight quarter below the nearly 10-year average of 1.24%. Are investors tired of earnings surprises, or is there something about the recent pattern that’s causing the divergence from historical norms?
We believe there are perfectly understandable reasons why positive earnings surprises have recently lost their stock-price-moving power. But we also believe those underlying reasons are temporary and positive earnings surprises should likely once again lead to stock price outperformance versus companies without positive earnings surprises.
Things that are rare typically garner more interest than things that are common
Perhaps the biggest reason for the lack of a price bump after an earnings surprise is that recently it’s not been much of a surprise. In this advancing economy and with lower tax rates, the true surprises might be on the negative end of the earnings spectrum. A greater percentage of companies are beating earnings expectations: In the first quarter of 2018, 78% of companies in the S&P 500 Index reported earnings above analyst expectations. According to Thomson Reuters, this is above the long-term average of 64% and above the prior four-quarter average of 72%. Just beating earnings expectations was not enough to result in positive returns during the quarter; as shown in the chart below, companies that beat earnings expectations by significant amounts (namely, 20% or more) posted better returns.
Source: FactSet; data as of May 25, 2018
Don’t let headlines distract from fundamentals
Some of the media headlines about peak earnings, the threat of an escalating trade war, or changes in inflation have all helped drive investor attention away from stock fundamentals. This is despite what we believe to be a lack of substantiating evidence to warrant heightened concern. For example, reduced earnings guidance caused the price of select manufacturing stocks to fall on days when these companies posted higher-than-expected earnings. That led to the front-page news topic of peak margins giving rise to escalating investor fears about the broader market outlook.
Headlines about the specter of rising inflation also garnered investor attention. Investor expectations for rising inflation have been one of the reasons for higher volatility and possibly the lack of stronger price reaction to an acceleration in earnings growth in 2018. Investors have been fearful of higher inflation, and that expectation could be coloring how they view current earnings. Thus far, however, inflation growth has been modest and we don’t expect it to surge anytime soon, largely due to disinflationary forces caused by slowing population growth and an aging population in the U.S.
Earnings reports are inherently based in the past, on how a company performed in a prior quarter. The current environment, however, is full of speculation about higher inflation right around the corner or the end of the decade-long bull market. Investors might be discounting positive earnings surprises because they don’t believe such outperformance will be sustained in what could be a tougher economic cycle to come. Why reward the past when you’re concerned about the future?
While news headlines may at times invoke emotional tensions, we believe it is better to focus on more fundamental influences that are more likely to affect stock returns, such as stable economic growth and the ability to deliver better-than-expected earnings. Indeed, we would argue that a positive earnings surprise isn’t simply a backward-looking metric. The reasons underlying those surprises matter, and those reasons, we believe, are pointing to the potential for continued corporate profitability spurred on by economic strength.
What are investors missing?
The impact of positive earnings surprises is likely to be felt beyond a four-day window. Investors often measure the impact of earnings surprises from two days before the company reported results through two days after the company reported results. By failing to reward companies that deliver positive earnings surprises, investors may be losing sight of longer-term implications. A positive earnings surprise, especially accompanied by improved guidance, has often been an indication of improving fundamentals and has frequently lead to consecutive earnings beats and positive price momentum.
Although there has been a muted short-term response to positive earnings surprises, we believe that a stock’s reaction to repeated earnings surprises over a multiyear period is more important than its reaction over a four-day window, as shown in the chart below. Companies that report positive earnings surprises have historically made more money for stock investors than those that have not, even if the short-term response to the surprise was lackluster. If a company’s share price doesn’t react to a positive earnings surprise and good guidance, that could be an indication that the stock is underappreciated and undervalued. The stock is more likely to have some firepower for next month and for next quarter and for several quarters after that. In short, we believe earnings surprises give investors such important long-term information about a stock’s possible trajectory that the lack of a short-term bump up in price during the four-day window doesn’t faze us.
Sources: Golden Capital and FactSet. The S&P 500 Index and positive EPS surprise returns are measured by selecting the constituents of the S&P 500 Index that reported a positive earnings surprise in the prior quarter and calculating their equally weighted total returns over the next quarter.
Summing it up
Many investors may still be hanging on to the misconception that the most important thing about positive earnings surprises is that they’re rewarded in the very short term. This might not always be the case. However, despite recent trends, positive surprises are valuable sources of information, and they are a lot better than the alternative. By focusing solely on the short term, market forces may be missing some key elements for a stock’s potential future outperformance. Longer-term trends clearly suggest that positive earnings surprises are rewarded, probably because they are indicative of companies getting stronger and more profitable. As the second-quarter earnings season heats up, we believe it’s important to remember that the best surprises are the gifts that have the potential to keep on giving.