Nowhere but the sheep farm does the “herd mentality” show up more than it does on Wall Street.
Unfortunately, sheep usually get slaughtered. In the stock market, if you’re doing what everyone else is doing, you’re going to get what they’re going to get: average returns.
Several years ago, I created a metric to predict whether Wall Street analysts would increase or decrease their earnings estimates for a company.
I was looking for a way to get on board before that herd moved…
Here’s how it typically works. Analysts like to make sure their earnings expectations are right around the consensus of their peers.
For example, if the consensus estimate for a company is to earn $1.00 this year, it’s not uncommon for the estimates to run from $0.97 up to $1.03. Some are below $1.00. Some are above $1.00. Nearly all are in the ballpark.
This is true even when an analyst is better at their job than the group and can correctly forecast where earnings are likely to be. If the company ends up earning $1.15 for the year, the best analyst probably will not have posted a $1.15 estimate… at least, not initially.
It boils down to “career risk.” If they put a $1.15 estimate out there and it’s wrong and clients lose a lot of money, well, that’s not good for the firm. Better to not stick your head out too far. It might get blown off.
A funny thing happens, though. As the year goes on, and it becomes obvious that a $1.00 estimate is too low, Wall Street’s finest will increase their forecasts. And the consensus will rise… slowly.
Eventually, the estimate will reflect the fundamentals. It could also overshoot as everyone falls over themselves to be bullish on the company.
By the time expectations match the fundamentals, the easy money has already been made. You’re late to the party.
How do you jump on the wagon before everyone else? If you can anticipate the Wall Street analyst, that’s potentially a big edge.
Here’s how I do it…
First, I look at the quality of earnings. I want to know that what’s reported by management has a shade of truth to them and are sustainable. I don’t pay attention to what’s touted in the headlines of the earnings release.
I always adjust for management’s potential shenanigans.
We don’t want CFOs with their hands in the cookie jar. The great thing is that when expectations are low, there’s little incentive to steal a penny or two of earnings. The situation is already dire, so why not just fess up? There’s no need to pull the wool over investors’ eyes.
Next, I’d like to see the stock react well to the earnings report. It means that someone is paying attention to the stock. They like what they see. That could be the start of a new, more powerful trend.
Of course, other factors play a role too. I assess the quality of cash flows, shareholder yield activity, and valuation.
The more cash a business generates, the better able it is to grow; it’s a virtuous cycle. And, when the market’s at historical levels, “value” is even more important.
Shareholder yield matters because over the past nearly 50 years companies that grow dividends have returned the most. Yep, something as old fashioned as paying a dividend has worked the best.
Buying back stock – if it’s done with quality cash flow and isn’t designed to artificially boost earnings per share – is also a key driver of long-term returns.
“Expectations analysis” has been a factor in my Forensic Accounting Stock Tracker software since I designed it 10 years ago.
I don’t know how much more legs the market has. But I do know that expectations matter, perhaps now more than ever.
I know that the recent spate of over-hyped initial public offerings of Uber (NYSE: UBER) and LYFT (Nasdaq: LYFT) haven’t helped. IPOs carry huge expectations, and they likely mean crappy returns going forward.
It’s one thing to look for new opportunities to profit. We like to do that. In fact, my FAST system is pretty good at identifying them…
But, right now is also a good time to look through your portfolio to identify stocks that may have gotten ahead of themselves. It’s a heady time, and that makes it easy to get lost in or trampled by the herd.
“Expectations” work both ways. Understand that, and your investment account will thank you for it.