Causeway’s dual research perspective combines insights from fundamental and quantitative research, and is the defining feature of our investment philosophy.
For nearly 25 years, we have been integrating these complementary investment approaches in a process we call “convergence.” This paper is the first in a series, highlighting how new areas of convergence have empowered our portfolio managers to address the challenges of value investing in today’s markets.1
The core of value investing involves buying unpopular stocks. But what prevents an unpopular stock from becoming even more unpopular? One of the major pitfalls of a value strategy is buying too early, trying to “catch a falling knife.” A stock trading at a single-digit price-to-earnings ratio may seem attractive, but it may not look as cheap if earnings suddenly plummet. Tracking the direction of earnings estimates can improve the successful timing of entry and exit points. In our experience, earnings estimates revisions complement a value-based strategy. Sell-side analysts frequently change their estimates for many reasons such as to reflect an upcoming change in the business cycle, adjust expectations for industry-wide data, or incorporate actual earnings results and management guidance. Earnings estimates revisions tend to be highly correlated with future earnings revisions, which are highly correlated with future stock price moves.
Value and Earnings Estimates Revisions – A Powerful Pairing
To improve the timing of buys and sells, we study the relationship between earnings revisions and stock price for clues on how to avoid the classic value manager mistake of buying too early (before the share price has reached a floor) and selling too early (forfeiting future alpha). In many cases, we can use earnings revisions to fine tune the trading aspect of our fundamental value strategies, slowing the buying of stocks with earnings headwinds and delaying the sale of those enjoying upward earnings revisions. We have found that extremely cheap stocks, however, sometimes warrant buying even as earnings continue to deteriorate, assuming the underlying company has superior financial strength. The converse generally also holds true: if we believe a stock’s valuation is likely to de-rate further, and earning revisions remain negative, then we have a signal that patiently waiting is likely to be rewarded with a more attractive entry price.
There are a variety of ways to quantify earnings estimates revisions. One approach is to measure “diffusion” of estimate changes, the ratio of upgrades to downgrades for different income statement items over a period of time. Another approach involves ranking analysts based on their historical efficacy, and upweighting those analysts who have the best results when comparing estimated earnings to actual earnings. Comparing this weighted average to the consensus average may indicate if the company will beat or miss the earnings estimates forecast by analysts. Quantitative analytics firm, Starmine, provides this data as part of its Analyst Revisions Model (ARM) scores. For purposes of this paper, we have constructed a simple measure of earnings revisions which consists of 50% earnings-per-share (EPS) estimate diffusion and 50% Starmine ARM score. Across all stocks in the MSCI World and Emerging Markets Indices, we compare these composite earnings estimates revisions scores to value scores in Exhibit 1.
Exhibit 1 illustrates a consistently negative correlation between earnings estimates revisions and value characteristics. Unsurprisingly, value stocks tend to have earnings estimates that are declining. This may be why they appear “cheap.” However, holding aside this typical relationship, let’s observe the historical returns of value-based and earnings-revisions-based strategies independently. To test the efficacy of an easily-replicable value strategy, assume we go long the 20% cheapest stocks and short the 20% most expensive stocks in the MSCI World and Emerging Market Indices, rebalancing monthly. To test earnings revisions, let’s assume we go long the 20% of stocks with the most positive earnings revisions over the past three months while shorting the 20% of stocks with the most negative revisions. The rolling 12-month returns to these strategies are shown in Exhibit 2 for both developed and emerging markets.
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