The Power of Revisions
When it comes to evaluating stocks, the concept of revisions can be a powerful tool. That’s because revisions have proven to have a strong correlation with the relative performance of stocks across market cap, style and domestic and international markets. Indeed, revision history is one of the things we look at when we are evaluating investment opportunities for inclusions in our portfolios and can explain some of the performance patterns we’ve seen over the past several years.
At a high level, a revision is simply a change in the consensus expectation of a fundamental metric for a company for a defined period. For example, it’s common to see earnings estimates for a company move higher or lower after the business reports its quarterly results. If earnings estimates move higher for the full fiscal year after the company reports a quarterly result, it is a positive revision, while the opposite is a negative revision. This characteristic, or factor, can be useful in understanding returns for individual stocks.
Revisions are important indicators of trend growth and positive/negative surprises. Purely from a factor perspective, revisions have typically been highly correlated with equity returns. The relationship between revisions and performance also adds valuable context to explain current market leadership. Incorporating revision trends into an investment philosophy that includes other factors can yield valuable diversification benefits, as the correlation levels between revisions and other popular factors like value are quite low and sometimes negative.
To illustrate the power of positive revisions, we can back-test a revision strategy using a variety of equity indices to determine factor-level performance, consistency and correlation levels versus other popular factors. In the chart below we look at the three-month trend of earnings revisions measured for the current fiscal year. On a sector-neutral basis, the strategy buys the top 20 percent of companies that have the highest percentage change in expected earnings when measured against expectations during the prior three months. The portfolio also simultaneously sells or shorts the bottom 20 percent (companies with the worst revision trends) as determined using the same calculation. Each basket of longs/shorts are equally weighted to prevent the back test from being influenced by the size factor, which could distort the historical performance of the revision factor. Lastly, the portfolio is rebalanced monthly to maintain an up-to-date basket of the best/worst revision trends on a sector-neutral basis.
As you can see from the results, earnings revisions have had a strong, consistent impact on performance since the end of the Great Financial Crisis. As a reminder, these are factor returns, not stock returns, which means that if the lines are moving up and to the right, it’s because the relative returns of the factor being tested are positive. Put simply, companies that deliver upside earnings surprises tend to consistently outperform companies that disappoint their shareholders with earnings that fall short of expectations. This factor performance is strong in the U.S. but even stronger in International Developed and Emerging Market equity indices.
The table below provides a detailed view of the one-year return profile of this factor using the broadest index, Bloomberg’s Top 3000 Global Index. The table highlights that the hypothetical portfolio using the positive earnings revision factor outperformed 89 percent of the time on a one-year basis. The median one-year performance for the portfolio was 5.95 percent. However, no factor is perfect, and there are some deeply negative one-year returns in the distribution, the worst being a loss of 21 percent. This reinforces the need for a portfolio that is diversified by factors and not relying simply on one category. Furthermore, this is just one revision factor measuring one specified fundamental metric (earnings per share) over a single time period (one year). There’s a seemingly endless number of fundamental metrics (sales, cash flow, EBITDA, analyst price targets, etc.) along with countless time measurement determinations.
Factors that find a home in our investment process not only have to demonstrate solid stand-alone performance, but they also need to make the overall process better by having diversification benefits. In the chart below, we graph the rolling one-year returns of this revision factor against a different factor category—value. The value factor uses a combination of value metrics (price/earnings, price/cash flow, enterprise value/earnings before interest, taxes, depreciation, and amortization, among others) and is also evaluated on a sector-neutral basis with monthly rebalancing. You can see the more volatile nature of value’s return profile, but if you’re also looking for a discernable correlation between the two return series, there isn’t one. The correlation between this revision factor and value over the last 20+ years is -0.02, making it an attractive source of diversification in the investment process.
Today’s factor environment
The lesson of revision factors is that they tend to correlate with segments of the equity market that are performing well on a relative basis. Applying that to our equity asset classes, you can begin to understand why the U.S. equity markets have dominated the international competition ever since the end of the global financial crisis. While U.S. equities have gotten more expensive versus their international counterparts, one of the reasons for their valuation expansion might be their superior fundamentals. The forward earnings estimate for the S&P 500 has grown 350 percent over the last 15 years versus just 44 percent for International Developed equities and 20 percent for Emerging Market equities. U.S. Small-Cap earnings have grown the most, followed by U.S. Mid-Caps and the Equal Weighted S&P 500.
By no means does this mean that this level of superior growth and corresponding revision profile will continue forever, but it helps to explain the vast majority of U.S. equity dominance during this long bull market.
Final word
Revisions are just one of many important factors that we analyze when making investment decisions. We believe it’s very important that the companies in our portfolios avoid consistently underperforming consensus expectations that cause a negative revision cycle. We’d much rather own companies that consistently deliver strong results against expectations that can be matched or beat. Put simply, revisions are a way of measuring fundamental momentum, and we want that important factor as a tailwind in our portfolio. That drives a strong positive revision profile, and as history has shown, it’s an important factor to include in portfolio construction.
Commentary is written to give you an overview of recent market and economic conditions, but it is only our opinion at a point in time and shouldn’t be used as a source to make investment decisions or to try to predict future market performance. To learn more, click here.
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