1/30/2007

Earnings expectations and Cinderella Strategy


Some days back I talked about the importance of overall contextual framework for any strategy. Once the conceptual framework is understood it is easier to implement a strategy. Much of the work on my earnings based modelling has been based on a book by Richard Bernstein.

Merrill Lynch quantitative strategist Richard Bernstein in his book Style Investing: Unique Insight Into Equity Management offers a very useful conceptual framework for understanding the role of earnings and earnings expectations in stocks price growth.

Bernstein's earnings expectations model compares earnings expectations of a typical company on a clock face. When a company is at its pinnacle in growth term it is at 12.00 midnight. In his book he offers a strategy to identify stocks early enough in their growth cycle. The idea is to find growth stocks early enough but not to overstay the party. That is why the name Cinderella strategy- you should not overstay the growth party and must leave the party before midnight.
The strategy basically offers a choice of value investing or growth investing based on how early you identify earnings potential of a stock.

12 to 3
12 o’clock: The company’s earnings are high and expectations are also very high
1 o’clock: Torpedo is a negative earning surprise
3 o’clock: Analysts revise earnings estimates downward. Growth investors abandon the stock.
3 to 6
4 o’clock: Earnings expectations continue to fall dramatically.
6 o’clock: At some stage earnings expectations reach their low point. At this point most of the bad news is priced in. Expectations are at lowest level.
6 to 9
This is where value investors focus. Value investors want to buy stocks neglected by market but which have the potential to surprise on earnings front. They want to buy it before the earning surprise. One of the risk of value approach is if you buy too early, you have to wait a long time.
7 o’clock: Stock has a positive earnings surprise. If it is a genuine turnaround there will be more surprises down the line.
9 o’clock: Market starts to recognise the stock and its earning potential.
9 to 12
This is where primarily growth investors focus. They want companies that have exhibited consistent earnings growth over several quarters. They pay premium for such stocks as the stock has already moved from low expectations to high. The value investors pass on these stocks to growth investors during this transition phase. The risk of growth investing is overstaying the party beyond midnight.
11 o’clock: Everyone becomes aware of the company.
12 o’clock: Earnings and earnings expectations reach peak.

The CANSLIM strategy primarily operates in the 9 to 12 quadrant. That is one of the reason many of the stocks on IBD 100 can break down also after appearing in the list. Earnings lead breakouts operates primarily in the 6 to 9 quadrant. Building a mix of earnings based strategies in the 6 to 12'o clock time frame gives you best of both worlds.
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