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What earnings season surprises say about a stock

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Investors are always on the lookout for an investment edge that will not only help them identify ‘quality-focused’ companies/avenues but also curate potentially winning strategies. Analysing quarterly results vis-à-vis expectations can play a key role in revaluating an individual’s existing holdings and ascertaining new ideas with the potential to generate alpha.

With the onset of earnings season, market participants typically shift focus from macro drivers like global economic developments and central bank action to stock and sector-specific drivers i.e. results, management commentary and guidance. These have an impact on investor’s expectation of a firm’s growth potential, portfolio positioning and hence the stock price.

Typically, market participants tend to assess earnings relative to expectations, as opposed to how much profit/revenue the company actually earns. A ‘positive’ surprise event is one wherein the company reports revenues / profits greater than analyst forecasts and conversely, a ‘negative’ earnings surprise is one where the company fails to meet analyst expectations on either of these parameters. Divergence in trends, for instance, positive revenue and negative earnings surprise can give interesting insights into an evolving business environment.

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Studies in the US markets have shown that companies that performed beyond expectations over the recent quarter were more likely to repeat the performance in the subsequent quarter. Also, markets tend to reward such companies with relatively higher returns. We analysed all the stocks in BSE-200 Index for their Q4-FY22 results and found similar takeaways. Q4-FY22 was a marginally positive quarter as 38% of companies delivered beyond expectations by at least 5%, while 31% reported in-line numbers.

Among the companies that reported a surprise of at least 5%, the average increase in projected earnings was 2.9% while the companies that disappointed saw an average cut of -0.9%, resulting in a healthy spread of almost 3.8%. Similarly, companies that reported a revenue surprise of at least 5% saw an increase in their revenue growth projections of almost 6.7% while firms that disappointed saw only a tepid improvement of 1.8%. In other words, if the investor’s portfolio had exposure to the companies that surprised positively, then the fundamental prospects at a portfolio level potentially got better and valuations moderated, assuming all else being equal. Besides, the stocks that surprised positively also outperformed their under-reporting peers by 7.4%.

If we consider quarterly data since 2018 beginning, the group of stocks that reported an earnings surprise of at least 5% outperformed the group of below par stocks by an average of 6%. Further this spread was positive in all but one quarter i.e. a success ratio of almost 95% over this period.

Being data centric and remaining steadfast to investing principles are key to longer term success. Tracking the earnings season and the extent of positive / negative surprises can be invaluable as they serve as a guidepost for a company’s business prospects over the coming quarters, thereby also affecting its stock returns.

Karthik Kumar is portfolio manager, alternative listed equities, Axis AMC.

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