ETF Securities: Can Earnings Generate Alpha?

March 04, 2015

[The following "ETF Issuer Perspective" is sponsored by ETF Securities]

Looking for earnings models to generate alpha

Analysis of companies' future earnings has generally been one of the key tools used by active fund managers to pick stocks. Surprisingly though, these strategies have not been directly implemented within the Exchange Traded Fund (ETF) space. To fill that gap, ETF Securities has partnered with Zacks Investment Research ("Zacks"), a pioneer in earnings analysis, to bring to market well established strategies that aim to deliver alpha to investors.

Using historical earnings

Some investments already in the marketplace have attempted to incorporate historical earnings into their investment models. For instance, WisdomTree Earnings Indices provide exposure to stocks that have generated positive earnings. These indices weigh eligible stocks based on their previously released earnings levels. This approach is simple and transparent and one would expect the audited earnings to be fairly accurate. However, the historical performance of these indices has been highly correlated with the S&P500 and the Russell 2000, hence there has been limited alpha generated over the period considered.

Using forecasted earnings

Fundamental valuation is based on the premise that a stock's intrinsic value is the sum of its discounted future earnings. The main source of earnings estimates is from brokerage firm analysts. Research has historically shown that equity analysts have generally been accurate at forecasting earnings (Gu of Carnegie Mellon and Wu of University of Rochester 2002). Research has also shown that the earnings consensus is fairly well incorporated into stocks prices (Elton, Gruber and Gultekin of New York University 1981), meaning that only focusing on equity analyst earnings forecasts is unlikely to generate alpha.

In addition to providing earnings estimates, equity analysts provide recommendations, which generally follow this classification:

  • Stocks that are expected to outperform the market are ranked "Buy" or "Strong Buy".
  • Stocks that are expected to underperform the market are ranked "Sell" or "Strong Sell".
  • Stocks that are expected to underperform the market are ranked "Sell" or "Strong Sell".

Historically though, recommendations from brokerage analysts have been tilted towards "Buy" or "Strong Buy", making it sometimes challenging for investors to effectively detect undervalued stocks.

Earnings Estimate Revisions

Let's consider for example Stock A, a company followed by 5 equity analysts with current EPS (earnings per share) consensus for next year of $10.00. The stock trades at 10x the forecasted EPS, so at $100 per share. One of the analysts met with Stock A's management few days ago and after the visit, released an updated forecasted EPS of $11.00. Following the release of this new information:

  • Should Stock A trade at $100, somewhere between $100 and $110, or $110?

While it seems impossible to have a definitive answer to this question, academic research has shown that there has generally been an under-reaction to analysts' forecast revisions (Gleason and Lee 2003, Zang 2006). In practice and continuing with the previous example, this means that an investor who bought Stock A right after the publication of a favorable earnings estimate revision, would have had on average and historically, earned more the broad market.

 

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