Earnings Surprises Earnings Surprises vs Earnings vs Earnings RevisionsRevisions

Taco Bandito:Taco Bandito:

Allen BornAllen Born

Mark DavidsonMark Davidson

Greg DaykoGreg Dayko

Stephanie ShayneStephanie Shayne

Ed ShenkanEd Shenkan

OverviewOverview

Comparison of Surprises to Comparison of Surprises to RevisionsRevisions

ImplementationImplementation ResultsResults Why it Works?Why it Works? CaveatsCaveats Taco TestTaco Test

Description of StrategyDescription of Strategy

Earnings SurprisesEarnings Surprises:: Accounting- Accounting-Based Earnings Momentum Strategy Based Earnings Momentum Strategy that exploits market under-reactions to that exploits market under-reactions to earnings surprisesearnings surprises

Earnings RevisionsEarnings Revisions:: Accounting- Accounting-Based Strategy that exploits market Based Strategy that exploits market under-reactions to revisions in earnings under-reactions to revisions in earnings estimates.estimates.

Implementation-SurprisesImplementation-Surprises

Created portfolios for the months Created portfolios for the months March, June, September, December March, June, September, December 1990-19991990-1999 – Compute the Surprise (% differential of Compute the Surprise (% differential of

Actual EPS to Expected EPS)Actual EPS to Expected EPS)– Long: top 5 % Surprisers Long: top 5 % Surprisers – Short: bottom 5 % Surprisers Short: bottom 5 % Surprisers

Equal weighting in longs and shortsEqual weighting in longs and shorts Held portfolios for 6 monthsHeld portfolios for 6 months

Implementation-RevisionsImplementation-Revisions

Created portfolios for the months Created portfolios for the months March, June, September, December March, June, September, December 1990-19991990-1999 – Compute the Revision (% Change in Compute the Revision (% Change in

expected EPS)expected EPS)– Long: top 5 % Revisions Long: top 5 % Revisions – Short: bottom 5 % Revisions Short: bottom 5 % Revisions

Equal Weighting in Longs and ShortsEqual Weighting in Longs and Shorts Held portfolios for 6 monthsHeld portfolios for 6 months

ResultsResults

Long Short TotalEarnings Surprises 36.61% 0.51% 37.12%Earnings Revisions 17.54% -4.23% 13.31%Difference 19.07% 4.74% 23.82%

ResultsResultsEarnings Surprises Earnings Revisions

Win Factor 28 10

Positive Portfolios 33 28

Negative Portfolios 5 10

Maximum Gain 106.07% 87.90%

Maximum Loss -16.36% -43.64%

Std. Dev of Returns 31.19% 24.67%

Why it works?Why it works?

Prices of equities for companies Prices of equities for companies recently announcing earnings recently announcing earnings surprises are mispricedsurprises are mispriced

Investors under-react to changes Investors under-react to changes in earningsin earnings– Mean revertingMean reverting– Anchoring biasAnchoring bias

CaveatsCaveats

We used quarterly EPS estimates for We used quarterly EPS estimates for revisions - Not annual EPSrevisions - Not annual EPS

Quarterly changes could be impacted byQuarterly changes could be impacted by– SeasonalitySeasonality– Unusual circumstances/Extraordinary Unusual circumstances/Extraordinary

EarningsEarnings We only included stocks which are presently We only included stocks which are presently

in the S&P 500 (i.e. Yahoo instead of Laidlaw) in the S&P 500 (i.e. Yahoo instead of Laidlaw) Used IBES returnsUsed IBES returns

Taco TestTaco Test

To eliminate seasonality, To eliminate seasonality, compared earnings forecast for compared earnings forecast for same quarter of prior yearsame quarter of prior year

Taco Factor

Positive Portfolios 27Negative Portfolios 7Maximum Gain 68.45%Maximum Loss -46.48%Std. Dev of Returns 20.74%

Questions & AnswersQuestions & Answers