Earnings Season, Like Life, is Full of Surprises, But So What?

Despite widespread criticism, many investors still regard so-called earnings “surprises,” calculated from quarterly earnings per share (EPS) reports compared to Wall Street analyst estimates, as useful information. The theory is that companies that consistent “beat” or “miss” the consensus Wall Street estimate deserve attention for that reason alone.

Since at least the mid-1990s, analysts and academics have blown two big holes in the earning surprise strategy. First companies are often able to manipulate the number they report to guarantee a positive surprise; second, the actual surprise may lie in the competence or incompetence of analysts who estimate EPS for the companies they follow, not in the performance of the companies.

Nonetheless, the current financial reporting season now in full swing continues to prompt coverage of “surprises.” Nasdaq stocks slipped in the middle of last week after Apple’s (AAPL) quarterly EPS, issued Oct. 18, failed to meet or beat analysts estimates for the first time in years ($7.05 reported vs. the $7.31 consensus estimate).

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On the other hand, pundits attributed the Oct. 21 advance in the Dow Jones Industrial Average in large part to a slightly positive EPS surprise from McDonald’s (MCD) ($1.45 reported vs. $1.43 consensus estimate).

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There probably is no way to diminish the undeserved role of earnings surprises in daily market coverage by the financial press. Long-term, value investors would be well serviced to ignore nearly all of them.

Toward that end, I crunched last week’s EPS reports vs. estimate numbers, as published by Nasdaq for insight into earnings surprises. My question was this: Does the “wisdom of crowds,” a theory popularized by the 2004 book of the same name by economics writer James Surowiecki, apply to earnings estimates? Statistical studies have shown that a large number of independent individuals guessing the number of beans in a jar are more likely to be correct than a smaller number.

Alas, even this simple proposition doesn’t hold for professional stock analysts, based on my look at last week’s results. I counted analyst estimates for stocks that reported at least a 10% positive or negative surprise compared to the consensus analyst estimate. A 10% surprise is likely to move a stock’s price in the hours or days after the report.

In a fairly busy earnings reporting week, 180 stocks scored at least a 10 percent positive or negative surprise (119 positive; 61 negative).

A total of 1,262 EPS estimates were issued for those 180 “surprising” stocks. Of that number, 726 estimates represented stocks with 11 or more estimates each – well followed stocks. Stocks in the group with fewer than 10 estimates accounted for 536 of the estimates. In other words, having more EPS estimates per stock does not improve the likelihood that the estimate will be less than a 10% error.

I’m not aware of any more comprehensive study on this phenomenon. But one factor may be at work. Stocks analysts, like any other professional group, are susceptible to group think. No one wants to be an outlier. Unlike random and independent bean counters in a crowd, the larger the group of analysts in the same club, so to speak, the more sheepish their behavior. As a result, the “consensus” estimate of a stock’s quarterly EPS is likely to reflect the characteristics of the analyst crowd, not the company’s performance.

Bill Barnhart is an editor for the YCharts Pro Investor Service which includes professional stock charts, stock ratings and portfolio strategies.