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   This is a translation of the former paper published by André Gosselin on the OrientationFinance.com web site on January 05 2005 ( Read the original paper in French here).


   How to cash in on securities whose expected profits are revised upwards by financial analysts.


   Claudia Mott is an authority in the institutional investors' circles specialized in the small capitalization securities. Prudential Securities first vice-president and director of the research centre on small capitalizations, Claudia Mott supports a mechanical and quantitative approach of the investment.

   One of the market anomalies she prefers is the surprise profits one. Research she conducts with her Prudential Securities team have convinced her that the strategy which consists in choosing securities according to the non expected profits (profits which exceed the analysts' expectations) is one of the best methods in the small capitalizations segment.

   A rather lucrative strategy of investment in the small capitalization company segment would thus consist in buying the securities whose expected profits have been revised upwards by the financial analysts of the large broker firms whose responsability is precisely to make recommendations.

   Such a strategy, based on the quantitative analysis, would have the advantage of functioning with any market conditions, it does not matter that they are growth or value securities, a bull or bear market, and it also does not matter what the industrial sector is.

   Satya Pradhuman, senior quantitative analyst at Merrill Lynch, includes in this model three criteria she balances the following way: 1- the first criterion, weighted at 40%, is the relative growth of the security price or what is called the price momentum (the more the price of a security increased over the last year, the better is its pointing); 2- the second criterion, weighted at 30%, is related to the extent of the revision, upwards, of the company profits by the analysts (the more the expected profits are corrected with a significant margin, the better the pointing of the security); 3- the last criterion, weighted at 30% of the final note, stresses a low price/cash flow ratio (a measurement similar to the price/earnings ratio, but less prone to accounting manipulations).

   From 1980 to 1995, this strategy, called Aurora, would have generated an average annual return of 31%. During a more bearish market, Pradhuman recommends to change the weighting of the three criteria as follows: 15% for the criterion of the profits revision, 15% for the stock momentum price and 70% for the price/cash flow ratio. This alternative of the model would have generated an annual return of 25% between 1980 and 1995. Interesting isn't it?

   André Gosselin

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