The earnings momentum strategy is an investment approach used by traders and investors to capitalize on the positive or negative trends in a company's earnings performance. This strategy amounts to buying winners and selling losers as in the price-momentum strategy, but the selection criterion is based on earnings.
It relies on the premise that stocks that have recently exhibited strong earnings growth are likely to continue performing well, while those with declining earnings are likely to underperform.
Here's how the earnings momentum strategy generally works:
1. Identifying Earnings Momentum: Investors analyze a company's recent earnings reports, looking for trends in earnings growth or decline. Positive earnings momentum refers to companies that have consistently beaten earnings estimates or shown strong growth in recent quarters. Negative earnings momentum refers to companies that have consistently missed earnings estimates or experienced declining earnings.
2. Selection Criteria: Stocks are selected based on specific criteria, such as the magnitude and consistency of earnings surprises. This could involve considering the percentage by which a company beats or misses earnings estimates, the number of consecutive quarters with positive or negative surprises, and the overall trend in earnings growth.
3. Portfolio Construction: Investors construct a portfolio of stocks that meet the criteria for positive earnings momentum. This could involve focusing on a specific sector or industry, depending on market trends and investor preferences. The goal is to build a portfolio of stocks with the potential for continued strong earnings growth.
4. Hold and Monitor: Once the portfolio is constructed, investors typically hold onto these stocks for a certain period, often until the next earnings reports are released. Since the strategy relies on earnings trends, it's essential to closely monitor the companies' financial performance and adjust the portfolio accordingly.
5. Rebalancing: Over time, as new earnings reports are released, the portfolio is rebalanced. Stocks that continue to show positive earnings momentum may be retained or added to, while those that show a decline in momentum might be removed or reduced.
It's important to note that the earnings momentum strategy comes with risks. Earnings surprises can be influenced by a variety of factors, including market sentiment, economic conditions, and company-specific events. Therefore, the strategy might not always lead to successful outcomes, and there's a possibility of overestimating future earnings based solely on historical trends.
Investors who employ the earnings momentum strategy often combine it with other methods of analysis and risk management to create a well-rounded investment approach. Like any investment strategy, thorough research, careful consideration of market conditions, and diversification are key elements to consider when implementing an earnings momentum strategy.
One kind of selection criterion is SUE.
Standardized Unexpected Earnings (SUE) is a concept introduced by Chan, Jegadeesh, and Lakonishok in their 1996 research paper titled "Momentum Strategies." This concept is closely related to the earnings momentum strategy and aims to quantify the magnitude of a company's earnings surprise relative to market expectations.
Here's how SUE works:
1. Expected Earnings: The first step involves calculating the market's consensus estimate of a company's earnings. This estimate is typically based on analyst forecasts or other relevant sources of information.
2. Actual Earnings: When the company releases its earnings report, the actual earnings for the period are disclosed.
3. Earnings Surprise: The earnings surprise is calculated as the difference between the actual earnings and the expected earnings.
4. Standardization: To make these surprises comparable across different companies and time periods, the earnings surprises are standardized. This involves dividing the earnings surprise by a measure of earnings volatility. Often, the standard deviation of the company's historical earnings is used for this purpose.
5. Standardized Unexpected Earnings (SUE): The standardized earnings surprise is referred to as the Standardized Unexpected Earnings (SUE). Mathematically, it can be represented as:
SUE = (Actual Earnings - Expected Earnings) / Standard Deviation of Historical Earnings
The SUE value provides insight into how unexpected a company's earnings report is compared to its historical earnings behavior and market expectations. A positive SUE indicates that the company's earnings exceeded expectations by a significant amount, while a negative SUE suggests that the earnings fell short of expectations.
In the context of momentum strategies, investors may use SUE values to identify stocks with positive or negative earnings surprises that are statistically significant. Companies with positive SUE values might be considered for inclusion in a portfolio using an earnings momentum strategy, as they demonstrate a history of beating expectations and potentially continuing that trend.
It's important to note that while SUE provides a quantitative measure of earnings surprises, it's not a foolproof indicator. Many factors can influence stock prices beyond just earnings surprises, and the success of a trading strategy based on SUE would depend on various market conditions and risk management practices.
Example:
Let's use a fictional example with data for Equity Group Holdings for the year 2023, applying the concept of Standardized Unexpected Earnings (SUE):
Assumptions:
- Consensus estimate for 2023 earnings: Ksh 10.00 per share
- Actual earnings reported for 2023: Ksh 11.50 per share
- Historical standard deviation of earnings for the past four years: Ksh 0.80 per share
Now, let's calculate the SUE for Equity Group Holdings based on this fictional data for the year 2023:
1. Expected Earnings: Ksh 10.00 per share
2. Actual Earnings: Ksh 11.50 per share
3. Earnings Surprise: Ksh 11.50 - Ksh 10.00 = Ksh 1.50 per share
4. Historical Earnings Standard Deviation: Ksh 0.80 per share
5. Calculate SUE:
SUE = (Actual Earnings - Expected Earnings) / Standard Deviation of Historical Earnings
SUE = (11.50 - 10.00) / 0.80 = 1.875
In this fictional example, the calculated SUE value for Equity Group Holdings in the year 2023 is 1.875. This positive SUE indicates that the company's 2023 earnings were Ksh 1.50 per share higher than market expectations, and this difference is significant relative to the historical volatility of the company's earnings.
