Earnings acceleration a valid means of equity selection
The relationship of earnings acceleration to outperformance has had only limited empirical studies. In fact, most studies focus on the US market, and we believe our research is one of the first to examine earnings acceleration in a global universe, by region and sector.
Earnings acceleration refers to the change in the velocity of growth in a company’s earnings. The exact point can be subjective, but it fundamentally refers to the stage when a company’s earnings growth experiences an inflection point on a sustainably upward path.
We conducted a study to further explore the relationship between earnings acceleration and outperformance. The study looked at stock performance in different countries and sectors, and the research was also designed to ascertain whether it was the size of the earnings acceleration, the direction, or the duration of the acceleration that was more important in determining stock outperformance.
The study measured earnings acceleration as the difference in the compound annual growth rate (CAGR) of reported earnings per share (EPS) figures between the next three years and the previous two years. Each EPS in the CAGR calculation was summed over 12 months.
The results were divided into companies experiencing positive earnings acceleration (accelerating) or negative earnings acceleration (deceleration). And companies were also grouped into deciles to drill down further into the findings.
WHAT DID THE STUDY FIND?
The study looked at the earnings of stocks in the MSCI All Country World index (ACWI) universe and found that stocks with earnings acceleration tended to deliver positive excess returns on a forward one, two and three-year basis. Stocks with decelerating earnings were associated with negative excess returns across the same time horizons.
The speed of the acceleration was also an important determinant, with stocks exhibiting the highest accelerating earnings more likely to deliver higher excess returns on average over time.
When separated into accelerating and decelerating earnings, the cumulative forward excess returns of the acceleration portfolio were 8.4%, 16.8% and 21.4% over the one-, two- and three-year periods respectively.
On average, there are approximately 822 companies in the acceleration portfolio compared to approximately 1,500 companies in the deceleration performance of the MSCI ACWI.
And when divided into deciles, decile one (i.e., the highest), showed cumulative forward excess returns of 11.6%, 24.1% and 29.4% over the one-, two- and three-year time periods respectively.
Chart 1 displays the linearity of the results when examining the excess returns of the universe broken into deciles of earnings acceleration.
It also highlights that the faster a company’s earnings accelerate, the more likely its stock will outperform the relevant benchmark over a one- to three-year period.
Another useful statistic the study measured is the information ratio of the accelerating (and decelerating) earnings stocks. The information ratio measures the risk-adjusted returns of a portfolio compared to its benchmark. A negative information ratio indicates an investment underperformed a benchmark. Any result over 0.5 is considered quite good.
In the accelerating group, the information ratio was 1.1 over the one-year period, dropping to an acceptable 0.8 for the three-year period. The information ratios for the decelerating group were negative for all time periods, and as low as -1.6 for the three-year time period.
When measured for the difference deciles, the results were similar, with information ratios of 1 or more for all time periods of the first decile.
The analysis covered the period of 2005 until 2017 and also revealed that the percentage of companies with positive earnings acceleration varies over time and can be cyclical in nature. During this 12-year period the percentage of companies with earnings acceleration ranged from a low of 17% in 2006 to a high of 47% in 2010.
When the market is coming off a low, such as the period immediately following the Global Financial Crisis of 2008/09, more companies displayed earnings rebounds. This trend has fallen off in recent years as a result of a more mature economic cycle globally.
REGIONS AND SECTORS
Studies to date have mainly examined US company returns and their relationship to outperformance. While these studies have shown a credible link, they haven’t explored this trend in other markets.
By applying the same analysis to the regional universes of MSCI ACWI – i.e., MSCI Europe ex-UK, MSCI USA, MSCI EM and MSCI Japan, we were able to conclude that the trend of accelerating earnings translating to stock outperformance is, in fact, international.
Stocks with higher earnings acceleration continued to outperform their peers in the country-specific indexes. Emerging market stocks appear to benefit most from earnings acceleration but the trend was also observed across European, US, Japanese and UK stocks.
Earnings deceleration can also provide a useful filter to screen out poorly performing stocks, particularly for US and emerging market stocks.
Another interesting finding was that the relationship between earnings acceleration and outperformance is not sector specific nor particularly concentrated in any one sector.
In terms of their composition of the accelerating group over the life of the study, sector allocations ranged from 5.2% in the energy sector to upwards of 16.5% across financials.
Looking at the one, two and three-year periods, there were also variations in the contribution to excess return by the different sectors. Information technology, for example, contributed 8.3% over the one year but as much as 15.8% to excess return over the three-year period.
Financials, on the other hand, had a declining contribution, falling from a 12.7% contribution to excess return over the one-year period to 4.1% over the three-year period.
The analysis shows that the earnings acceleration occurs consistently over time in each equity sector. Many investors often equate earnings acceleration with traditional growth sectors like technology or health care, however, the data demonstrates that earnings acceleration occurs in companies in every sector of the economy, including more traditional value sectors like financials and industrials.
EQUITY FACTORS
Asset managers receive a lot of questions about equity factors in meetings with clients. Often people will equate earnings acceleration with price momentum, so a further pillar to the study was to analyse the relationship between earnings acceleration and the equity factors of momentum, value and size. If earnings acceleration was related to any of these equity factors, then it may not be a useful predictor of enhanced performance.
The study used a T-Test to determine if there was a significant relationship between these equity factors (the T-Test measures whether there is a significant difference between the means of two groups, with a negative T-statistic indicating there is not). The analysis found a negative T-statistic for momentum and size, and a small positive T-statistic for value, as measured by book to price.
The modestly positive relationship between earnings acceleration and value suggests the alpha associated with earnings acceleration may be distributed across the growth and value-oriented sectors of the universe, with a modestly increased incidence in the latter.
REAL WORLD USE
It's important to remember that earnings acceleration can be a useful compliment to an overall equity process, rather than a sole consideration. It is also useful to consider the drivers and durability of earnings acceleration as part of the process, as there are many reasons that can cause earnings to accelerate.
That said, the research shows that the excess returns of a portfolio of stocks with accelerating earnings are durable and persisted through the different market environments examined as part of the research. The relationship was also consistent in all equity sectors, which demonstrates durability and independence from style bias.
When applying an earnings acceleration screen to a portfolio, common sense must also be applied. For example, for an early-stage software company it would be prudent to look more closely at revenues as opposed to earnings. But there is certainly value in considering earnings acceleration as an overlooked source of excess returns in any portfolio.
Laura Granger is senior client portfolio manager at American Century Investments.
CPD QUIZ ACCREDITED
This activity has been accredited as continuing professional development by the Financial Planning Association of Australia but does not constitute FPA’s endorsement of the activity.
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