The document analyzes whether investors can outperform the market by reacting to positive or negative earnings surprises alone. It finds that while earnings surprises previously helped generate returns, that correlation disappeared after 2000 likely due to regulations that leveled the playing field for information access. Specifically, it shows positive earnings surprises do not lead to subsequent outperformance, and negative surprises do not cause underperformance, for both large-cap and small-cap stocks in recent years. The document concludes earnings surprises alone are not a reliable basis for trading and investing decisions.

1. Investors Should Be Wary Of Trading On Positive/Negative
Earnings Surprises Alone
Global equity investors are correct to closely follow the quarterly corporate earnings cycle, since
in the end it is current reported, and more importantly, expected future earnings growth that
drives market psychology and the direction of stocks over the intermediate to long-run, in our
opinion. Put another way, where the outlook for profitability and the outlook for the direction
of the stock market is concerned, as we like to say, "you can't really know where you are going
unless you know where you have been." As companies report their results, the focus very often
becomes whether companies beat, missed, or met their consensus earnings "number." But are
investors well-advised to invest or even trade on reported quarterly earnings based on whether
any given company was able to "beat the Street" in any given particular quarter? The Global
Markets Intelligence (GMI) team at S&P Capital IQ decided to investigate this question, and
determined the following:
• We believe that earnings surprise, a widely followed indicator of company performance,
should not be used as the sole basis for either trading or investing decisions.
• We show that positive earnings surprises, as a basis for trading, has not produced higher
excess returns in recent years for S&P 500 or S&P 600 index member stocks.
• Likewise, using negative earnings surprise as a basis for selling shares does not result in
underperformance versus the market for either index.
• However, on a qualitative basis, we view earnings surprise as a good indicator of a
company's ability (or inability) to generate earnings in excess of expectations, and hence of
the general health of a company's operations, especially when a company is able to post a
string of positive surprises (or when a company is consistently unable to meet estimates and
posts a series of negative surprises).
• In addition, we'd suggest that when evaluating performance, investors consider earnings
surprise within the context of earnings growth. A modestly negative surprise or two within a
strong earnings growth trend is not necessarily fatal in our view, while a slightly positive
surprise with earnings per share (EPS) declining is not necessarily a call for celebration.
• Further, as with much in the market, moderation is often a good thing: a string of moderate
earnings surprises amid moderate earnings growth can often mark a stable and sustainable
earnings growth trajectory for a company--and one that might well be profitable to the
Market Intellect
from Global Markets Intelligence
July 2, 2014
Robert A Keiser
Vice President
Global Markets Intelligence
(1) 212-438-3540
robert.keiser@spcapitaliq.com
Jaseem Hasib
Vice President, Quantitative Research
Global Markets Intelligence
(1) 212-438-1158
jaseem.hasib@spcapitaliq.com
This report was prepared by the S&P
Capital IQ Global Markets Intelligence
group. This group is analytically and
editorially independent from any other
analytical group at S&P. The objective
of this group is to provide unique
financial intelligence by analyzing
relationships across multiple asset
classes and markets. Enabled with
cutting-edge S&P Capital IQ and
third-party applications and data, the
group offers investors valuable new
sources for alpha discovery and
"out-of-the-box" thinking through
robust data exploration and analysis.
The research provides investors with
actionable and topical market
perspectives that can offer innovative
ways to leverage credit and risk
intelligence.
1341026 | 301116611

2. investor, given attractive valuations.
Can investors outperform the broader market by reacting to earnings surprises?
Looking at the S&P 500 and S&P 600 indexes, the answer to the above question seems clear based on the empirical data.
In aggregate and over an extended period, companies that report positive earnings surprises do not subsequently see their
stocks outperform the market, and stocks that surprise negatively, conversely, do not underperform. However, our
time-series analysis reveals that earnings surprises have previously helped generate alpha, but the correlation has ceased to
exist since the year 2000, presumably as investors have become smarter and more efficient in evaluating the sustainability
and true value of earnings surprises.
Methodology
EPS estimates and actual analyst-adjusted values were gathered for S&P 500 companies on a quarterly basis from 1987
through early 2014. The consensus estimate was compared with the actual "operating" earnings, as reported by the
company, to define the earnings surprise. Companies with the highest positive surprises were placed into quintile one (Q1)
and those with the highest negative surprises were placed in quintile five (Q5).
Analysis
The monthly returns of the five quintile-based portfolios are presented in Chart 1, arranged from highest positive surprise
(Q1) to highest negative surprise (Q5). Portfolios are rebalanced monthly, and forward returns are calculated for the
succeeding month.
The blue bars represent performance results (total returns) from March 1987 to September 2000. Note that companies
with the highest earnings surprises did outperform the S&P 500 by a 4.2% annual average over this period. Likewise, the
companies with the highest negative earnings surprises over the 1987-2000 period underperformed the S&P 500 by 2.9%
on average.
However, beginning in September 2000, the relationship between earnings surprise and stock performance changes
dramatically. The yellow bars represent results from September 2000 to March 2014. Over this period, companies with
the highest positive earnings surprises (Q1) underperform the S&P 500 by 2.4% on average and those with the highest
negative surprises (Q5) outperform by 2.3% on average.
Note: "Active" returns mean total returns (with dividends reinvested) in excess of an index benchmark, which is the S&P
500 in this case.
Investors Should Be Wary Of Trading On Positive/Negative Earnings Surprises Alone Market Intellect from Global Markets Intelligence
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3. Chart 1
What happened in 2000 to effect this change? While numerous factors likely contributed, we believe a significant influence
is Regulation FD, which was enacted by the Securities and Exchange Commission on August 15, 2000 (the rule took effect
in October 2000). FD stands for Fair Disclosure, and the rule states that anytime a company discloses material non-public
information to stock analysts or large investors, the company must also publicly disclose that information. Basically,
Regulation FD helped level the playing field, with regard to information access, between market professionals and the
public, in our opinion.
We believe the effect of Regulation FD on earnings surprise was that company data that was once available to relatively
few individuals then became much more widely available and distributed to the investing public, and hence, the prospect
of earnings surprises became more widely anticipated and thus priced into security valuation.
In looking over the data for fourth-quarter 2013 earnings season for the S&P 500 companies, a few patterns become
apparent:
Some earnings reports indeed take the market by surprise, but are quickly discounted in the stock price--and hence are not
tradable by the average investor:
• Caterpillar Inc. reported a 23% positive surprise in January--the stock rose 6% the day of the surprise and about 3% in
the four following days, but then underperformed the market.
• Homebuilder DR Horton Inc. reported a 24% positive surprise in January--the stock rose 10% that day and 2% over
Investors Should Be Wary Of Trading On Positive/Negative Earnings Surprises Alone Market Intellect from Global Markets Intelligence
3 July 2, 2014
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4. the following three days, but then became a market performer.
Some earnings reports result in "surprises" that are ignored by the market--other factors are deemed more significant (e.g.,
forward guidance).
• Vertex Pharmaceuticals Inc. reported a 144% positive surprise in late January--the stock rose 4% on the day, but
underperformed the S&P 500 by 2% in February and 13% in March.
• Broadcom Corp. reported a 5% surprise in late January--the stock rose 2% on the day, but then underperformed for
the month of February.
Sometimes positive earnings surprises result in a pop in the stock price on the day of earnings followed by continued
outperformance. Although this type of surprise is tradable, we don't see a good way for the average investor to
differentiate it from other types of EPS surprise.
• Eastman Chemical Co. reported an 8% positive surprise in late January, rose 3% on the day, and outperformed the
market by 8% in February.
• Wynn Resorts Ltd. reported a 31% positive surprise in late January--the stock rose 4% on the day and outperformed
by 9% in February and 9% in March.
A positive surprise is sometimes met by investor selling, but the stock is then reevaluated, turns around and rises strongly.
Again, we see no easy way to tell when this will occur. Also, it is possible that factors other than the surprise are driving
the turnaround in the stock.
• Phillips 66 reported a 26% positive surprise in late January and the stock declined for five days. It then went on to
outperform the S&P 500 by 2% in both February and March.
• KLA-Tencor Corp. reported a 6% positive surprise on January 23.The stock fell by 6% over the following several days,
but then outperformed by 2% in February and 5% in March.
In sum, for the S&P 500, positive earnings surprises are generally a sign that things are progressing well for the company,
but, profiting from the earnings surprise alone is difficult.
Even for small cap stocks, earnings surprise alone as a strategy has been a tough one in recent years. Chart 2 shows active
returns by earnings surprise quintile for the S&P 600. (Active returns mean returns in excess of the S&P 600 index
average)
From 1994 (index inception) until April 2006, the earnings surprise strategy worked very well for S&P 600 companies
(blue bars). However, the strategy stopped working (or worked in reverse) from that point until the present. We believe
that, like the S&P 500 stocks, the S&P 600 stocks became more efficient at discounting positive and negative news over
time.
Note: Results for the S&P 400 were very similar to S&P 500 results, with outperformance by the top quintile (highest
earnings surprise) ending in August 2000. Due to this similarity we have not presented S&P 400 results here.
Investors Should Be Wary Of Trading On Positive/Negative Earnings Surprises Alone Market Intellect from Global Markets Intelligence
4 July 2, 2014
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5. Chart 2
Contact Information: Richard Tortoriello, Director, Quantitative Research—Global Markets
Intelligence, Richard_Tortoriello@spcapitaliq.com
Investors Should Be Wary Of Trading On Positive/Negative Earnings Surprises Alone Market Intellect from Global Markets Intelligence
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