Returns based on Estimate Revisions

Estimate revisions are an important as representation of near term business dynamics of the companies being considered.

Estimate revisions provide a measure of direction and magnitude of the change in the expectations about a company’s earnings. The assumption is that rising estimations are associated with the above average stock returns and falling estimations are associated with the below average stock returns. Revisions tend to be positively serially correlated i.e. positive revisions are followed by positive revisions and negative revisions are followed by the negative revisions. It is difficult for an analyst to judge how far a positive or negative trend will go on once it has begun. Studies show that analysts are sluggish to respond to new information. They react slowly to a change in the direction of the underlying fundamentals because of a natural unwillingness to believe the change. In behavioral finance this is bias is known as anchoring where analyst remains anchored to his earlier forecasts and does not fully incorporates the new information due to conservatism. This phenomenon is strong on the downside because of the reluctance of the analysts to make negative comments about a company with which he may have investment banking relationships. As a result, the analysts issue frequent, minor revisions instead of marking their estimates down all at once.

Anchoring leads to earnings surprise. Positive earnings estimates are followed by positive surprises. For example, analyst has predicted that earnings of a company will increase by 10%, he receives the information that earnings will increase by 25%, but due to anchoring, he may not fully incorporate the news and uses only 15% increase in earning estimates. Over the time, when 25% earnings increase is reported by the company, stock will outperform the analyst expectation by 10% (positive earnings surprise). The positive earnings surprise leads to frequent positive estimate revisions. There is a kind of virtuous cycle when company’s earnings are improving. Of course, opposite is true when underlying fundaments are deteriorating.

To trade in this market by stocks which report positive earnings, of course we assume that markets are inefficient due to the heuristics.

P.S.: The extra returns based on near term business dynamics are difficult to capture than those based on the measures of value because of the greater trading activity required.