is earnings upgrade by analysts an important metric for stock selection
In this blog, we will see how important is analyst’s earnings upgrade in picking stocks. The purpose will be to backtest a strategy that picks stocks that have seen high earnings upgrade in the last 3 months.
But before that, some definitions.
Most analysts have forward-looking estimates for a company’s earnings per share (EPS). For example, in August 2023, analysts would have estimates for EPS in FY2024, FY2025, and in some cases, even FY2026.
These estimates tend to change with time with changing dynamics (bumper quarterly results or some bad regulatory news and so on). It is generally considered that stocks that have seen an upward revision in earnings tend to outperform in subsequent periods.
Let’s put that to the test.
On sharpely, we capture earnings revision using a metric called Earnings upgrade (3M). This is calculated by dividing the current EPS NTM by EPS NTM estimate 3 months ago. This gives an indication of how much the consensus EPS estimate has been revised upwards (or downwards).
Note that we use a rolling version of the EPS estimate - EPS NTM (next twelve months). NTM estimates are calculated as the weighted average of estimates for the next 2 financial years. The weight assigned to the next financial year estimate is equal to the number of days remaining in the financial year divided by 365. The rest of the weight is assigned to the next-to-next financial year estimate. More details here.
Should an investor look to buy stocks that have seen the highest earnings upgrade in the last 3 months?
Let’s run our standard metric performance backtest on the Earnings upgrade (3M).
Under the hood, here is what happens (more details on backtesting of metric can be found here):
1. We first select a universe - Nifty 500 in this case.
2. Stocks in the universe are sorted in ascending order and then portfolios are created based on percentiles. So, Quintile 1 will have stocks in 0 – 20 percentiles while Quintile 5 will have stocks in 80 – 100 percentiles. For each portfolio, stocks are assigned an equal weight in the portfolio.
3. Using our standard walk-forward framework, 5 such portfolios are constructed every quarter (based on quintile splitting) and portfolios are rebalanced to new stocks.
Note that in our case, Quintile 5 portfolio is the one that contains stocks with the highest EPS upgrades in the last 3 months. Quintile 1 portfolio, on the other hand, contains stocks with the lowest EPS upgrades (and even downgrades) in the last 3 months.
If EPS upgrade was a useful metric for stock selection, we would expect Quintile 5 portfolio to outperform Quintile 1 portfolio.
Let’s see the results.
Looks like we have a winner!
In the last 10 years, Quintile 5 portfolio has delivered a CAGR of 16.11% which is almost 800 bps higher than the Quintile 1 portfolio. And as we move up the quintile, we can clearly see the performance getting better.
So yes, picking stocks that have seen significant earnings upgrade in the last 3 months can be a winning strategy. In fact, this metric plays an important role in calculating earnings momentum score which is then used as an input for the final momentum score.
Note that different stocks have different numbers of analysts covering them and therefore using an aggregated measure has its own pitfalls. We have tried to circumvent this problem by including only those stocks that were covered by at least 5 analysts.
Also, standard disclaimers associated with back-tested results apply.