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.

5 comments:

Unknown said...

what will the fed do today and how might it affect the markets/indicies?

Pradeep Bonde said...

Nothing. They will do nothing. Market is in rage so it can go either way.

walter said...

nothing already priced in?

we'll find out soon enough

Koppenhagen said...

Just remember that the first move right after the announcement tends to be the fake move. Also, S seems to be in around 6:00. What do you think?

Unknown said...

What will matter is the Fedspeak re: prospects of economic strength, inflation, and interest rates. The optimal bull scenario would be economic strength with contained inflation and a dovish spin on interest rates, of course. The inverse for the best bearish case. The reality will probably be a mix: economic strength, currently contained inflation but outlook is uncertain, and a hawkish spin on interest rates. If this is the case, expect the status quo to sustain--choppy upward bias.