Morgan Stanley
  • Research
  • Sep 9, 2020

A New Take on the Earnings-Surprise Strategy

Amid the global pandemic, guidance on earnings has become more unpredictable than ever, but investors who focus on high-quality factors could uncover long-term winners.

Uncertainty has been a prevailing theme since the start of the COVID-19 pandemic, and company earnings seem to be no exception. The unprecedented nature of the global economic shutdown forced many companies to withdraw earnings guidance. Just 26% of companies in the Russell 1000 are now providing guidance, compared with 47% in 2019. And only 8% of companies in the Russell 2000 have shared guidance, down from 21% a year ago.

While murky earnings outlooks add a whole new dimension of risk, they can also open doors for positive surprises.

This lack of guidance and clarity has resulted in large number of earnings surprises. Heading into the first quarter, investors have underestimated the impact of COVID-19 on corporate bottom lines. Among the 1,500 largest companies in the Russell 3000, an index that represents about 98% of all U.S corporations, the number of companies missing first-quarter earnings estimates this year rose by 57% from the previous quarter.

In the second-quarter, on the other hand, 60% of the largest 1,500 Russell 3000 constituents have beat earnings estimates, with a total reported earnings exceeding consensus expectations by 27%, the largest beat in a decade.

While murky earnings outlooks add a whole new dimension of risk, they can also open doors for positive surprises. “The key for investors is having a trading strategy that separates true economic break-outs from technical noise," says Boris Lerner, Global Head of Quantitative Equity Research at Morgan Stanley. “At the end of the day, it's all about the quality of earnings."

Percentage of Companies Providing Annual Earnings Guidance 2006-2020

Source: FactSet, Morgan Stanley Research

Trading on the back of earnings and revenue surprises is hardly a new strategy. However, most academic research focuses on the magnitude and direction of the surprise, and immediate stock price changes following the announcement. Lerner and his team expand on this by looking at the quality and stability of earnings.

The result is a proprietary “Quali-SURE" score and trading strategy. “We’ve found that one of the best ways for investors to find alpha in earnings surprises is to go long high-quality stocks that have recently beaten consensus earnings and revenue estimates, and short low-quality stocks that have missed expectations," Lerner says.

Russell 1500: Annual Return and Information Ratio, Surprise and Quality Metrics (Jan 1994 - Jun 2020)

Source: I/B/E/S, ClariFI, Morgan Stanley Research. Note: The performance data provided is a hypothetical illustration of mathematical principles, it does not predict or project the performance of an investment or investment strategy. Past performance is no guarantee of future results.

Quality Matters, Especially Now

Not all earnings surprises, even the positive ones, are created equal. It's often the case that an earnings surprise can be the product of cost-cutting, creative accounting and other quick fixes.

A far better approach is to look for high-quality earnings, as well as revenue surprises, which tend to be the result of strong revenue growth. “Although revenue growth alone does not define a high-quality company, it is a strong indication that there is demand for its products or services," Lerner says.

During the 2008 Financial Crisis, notably, investors disproportionately punished companies that disappointed on both revenue and earnings, while rewarding those that missed on earnings but beat on revenue.

Quality factors can also reflect the overall health of the underlying company. These include metrics such as profitability, accruals, operational efficiency, leverage, as well as the stability of earnings, which Morgan Stanley defines as low variability in return-on-equity, low estimate-dispersion and high sales-stability, all relative to a company's respective sector.

For the purposes of earnings surprise analysis, the team focused on earnings-related measures of quality, such as accruals and earnings stability.In a simulation covering the period starting January 1994 and lasting through June 2020, a strategy that combined composite surprise and earnings quality delivered a 7.7% annual return, vs. 2.5% for a strategy focused solely on composite surprise, and 5.0% for another focused on earnings quality.

“Investors are more likely to reward companies that not only surprise on earnings and revenue but also demonstrate the potential for consistent performance," says Lerner.

Not Just Small Caps

A common belief among investors is that combining earnings and revenue surprises is most applicable to smaller companies—liquidity (i.e., how easy the stock is buy and sell quickly) being a key factor. Yet, in their analysis, the researchers found that post-announcement outperformance driven by earnings and revenue surprises tends to persist across all capitalization categories and trading-volume levels. Put another way, liquidity can’t fully explain earnings-related alpha.

“In fact, our work shows that stocks that beat consensus earnings or revenue expectations tend to outperform stocks that missed expectations over the subsequent one and three months, and this holds true both among liquid and less liquid stocks," Lerner says.

Lerner and his team tested this by looking at the largest 1,500 names in the Russell 3000. Between 1993 and 2004, surprise-driven outperformance was more prominent among smaller and less-liquid stocks. Yet, performance over the past 16 years has been more balanced across different size and liquidity cohorts.

Large/Mid/Small Caps: Standardized Unexpected Earnings Annual Returns

Source: I/B/E/S, ClariFI, Morgan Stanley Research

This isn't to say that the one-size approach works in every market environment, across every category of stocks. In their analysis, the team found that earnings-surprise outperformance tends to be higher in down markets, which is also the case for revenue surprises among small- and mid-cap stocks. It's a different story for larger companies, where performance driven by revenue surprises tends to be higher in up markets.

For more Morgan Stanley Research on earnings surprises ask your Morgan Stanley representative or Financial Advisor for the full report, “Finding Alpha in Surprises" (Aug 6, 2020). Plus, more Ideas from Morgan Stanley's thought leaders.