Predicting the Big Earnings Surprise

Earnings surprises aren't all that rare -- about 60 percent of companies post quarterly results that are better than the forecasts of Wall Street analysts.

But nobody knows for sure which companies will have a positive, or negative, surprise in any given quarter. And in the current market, investors are quick to punish a company's stock if results are below expectations, or even if the company doesn't beat estimates by a wide margin.

Greg Forsythe, senior vice president of Schwab Equity Ratings at Charles Schwab Corp., says there are a number of common elements to companies whose earnings come in ahead of projections. Most are based on psychology, not complex financial equations.

"For one, investors tend to overreact to, or extrapolate, long-term trends," he said. "If a company grows earnings at a great rate, or its earnings are poor for a long period of time, analysts' forecasts tend to become too high or too low."

In addition, investors and analysts can overlook recent news if it doesn't necessarily fit into their long-term view of the company. So if a company has had high-flying earnings growth for years, analysts may give less credence to recent negative news simply because it doesn't fit in with their mindset.

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"People tend to stick to the beliefs they form, and then if there's news that runs counter to those beliefs, they tend to discount it," Forsythe said.

Schwab has used that psychology to come up with ways to predict which companies are more likely to beat Wall Street in a given quarter, and have wrapped those predictions into the Schwab equity rating system. Companies that may have a positive surprise are given a higher grade than those that may not.

The system seems to work. Of the stocks Schwab has rated with an "A," their earnings have beat Wall Street's forecasts 74 percent of the time. Those rated "F" have a positive surprise just 41 percent of the time.

Forsythe believes the average investor can also identify potential "surprise" companies with time and research by looking at a few relatively simple factors. For one, their stocks tend to be cheap, and have remained cheap for at least a few quarters if not longer -- a reflection of the market's belief that a company that's been down will stay down.

Another factor: If these cheap companies have been returning cash to investors through dividends or share buybacks, they tend to feel more comfortable with their performance and aren't keeping cash on hand for a crisis. Likewise, if corporate insiders are buying up shares, that's a strong sign that the fortunes of the company could be on the rise.

Finally, if the company's recent performance is notably higher than its long-term pattern, it's more likely that earnings will show some upside. Forsythe looks for sales growth that exceeds asset growth, positive forecast revisions from analysts, and a recent jump in the company's share price.

Those criteria work in reverse, too. If the company has had a long history of strong earnings growth, yet dividends are drying up, insiders are selling and analysts are turning negative, the surprise could be to the downside. Or even if earnings are better than expected, it may not be enough to mollify disappointed investors.

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