What is better than a surprise birthday party? Answer: Your equity investments reporting unexpected profits.
Stocks frequently appreciate following unexpected good news. Recognizing this phenomenon, investment industry databases have created variables designed to identify earnings surprises, measure the degree of surprise, and keep track of a series of surprises. Due to the relationship between positive earnings surprise and positive subsequent stock performance, consideration of earnings surprise has become a factor in good investment decision making. Earnings surprise meets the common sense test as well. It’s hard to argue that unexpected and higher earnings would be a negative for stock valuations. Earnings surprise is a key component of JAG Capital Management’s multi-factor model.
Earnings surprise has been considered a positive investment factor since 1968 when Ball and Brown identified a phenomenon entitled, “post earnings drift.” Similar studies in 1984 and again in 1995 affirmed the earliest findings. An anomaly persisted for over 30 years that stocks continued to appreciate for as long as 60 days following a positive earnings surprise. Among several theories to explain this finding, the most often cited is that it likely takes time for the market to fully disseminate good news.
While the earnings surprise factor has worked well for decades, it did have time periods where the factor was less successful. One of those times occurred in the late 1990’s. Such periods are not atypical as discreet factors can lose power as more and more investors understand and attempt to exploit a market anomaly. During one of those down times for the earnings surprise factor, investment practitioners sought to improve the indicator. Several new studies were published near the turn of the century which attempted to isolate items ranging from the number of analyst estimates for a stock, to whether the stock was a value or a growth stock, to events subsequent to the earnings surprise.