* Extract written by André Gosselin published in his
book "Investir dans les titres de petites entreprises".
The work of financial analysts can be described
as such: They seek to forecast the results found in company quarterly
and annual financial reports. Upon publication of these financial data,
analysts react by either reiterating their forecasts and
recommendations, or by revising them if the financial results deviate
substantially from their predictions In this last case, they try to
justify themselves and to give the reasons why the actual results of
the company deviate so much from their forecasts. An aspect of the
analyst job thus consists in stating in their reports justification
arguments, a kind of subtle rhetoric, by which they explain their
Most of the analysts readjust their forecasts and
their recommendations as soon as possible after the companies' profits have
been published. These revision activities are obviously more significant
when the financial results of the companies deviate from the forecasts (in
particular when the actual profits are lower than the expectations) and when
several analysts follow the same company. When the profits exceed the
analyst's expectations, this one is reassured and will write a new report
only if he is convinced that he must upgrade his forecasts for the next
quarters. When, on the other hand, the profits are lower than his
expectations, the analyst feels obliged to remake his duties and to justify
himself, even if he is convinced that his forecasts will not change for the
In particular, the intense readjustment activity of
the analysts' recommendations and profits forecasts is deeply related to
what is called the surprise profits. It is enough to follow the analysts'
profits revision activities and recommendations' updates to spot securities
with returns higher than the average. Moreover, the bigger the difference
between the initial forecast and the corrected one, the higher the stock
price rise in reaction and the longer this reaction lasts (up to six
months). Financial science has largely demonstrated this causal relation so
I'm not insisting there too.
The investor tends to believe, not without reason,
that when the analyst renews his recommendations, he also readjusts his
profits forecasts of the companies. Of course, a buy or sale recommendation
can change for several reason, but, generally, if the analyst readjusts his
recommendations, that is because he has adjusted his profits forecasts.
Professors Jennifer Francis and Leonard Soffer (in
1997) showed that, for a given security, the changes in the analysts'
recommendations have an effect on the stock prices which is partially
independent of the changes in their profits forecasts. They noted, however,
that the investors attach a greater importance to the profits revisions when
they come with a recommendation to hold or to sell the stocks.
Surprise profits and small capitalization
securities: an excellent vein
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.
We already know that the companies which publish
profits higher than the analysts' expectations and professional investors
tend to overperform in a substantial way during the few months which follow.
This surprise effect, if we believe Graja and Ungar, would be amplified
within the small capitalization securities. For instance, providing positive
profits higher than the analysts' expectations generate on average, in the
small capitalization category, a performance of the stock 13,7 % higher
that the average for 3 months, against 5,7 % for the big capitalization
The first works about the unexpected profits of the
companies and their effects on the security prices go back to the beginning
of the 70s, in particular, thanks to the contribution of professors Latané,
Jones and Rieke. They have discovered that, when companies declare profits
unexpected by the analysts, higher than what they were waiting for, the
price of their security enjoys a performance beyond the average. The
researchers have also observed that if unexpected profits are announced for
one quarter, it is likely that the publication of the next quarter results
will also include profits unexpected by the analysts. This phenomenon is
called "the cockroaches' theory". As the presence of a single cockroach is
the clue that others are hidden, one quarter of surprise profits hardly comes
alone. And this, no matter what the size of the companies is.
Among all the factors included in the quantitative
models tested by Claudia Mott, the "surprise profits" effect is the one
whose performance is the most constant in the small capitalization market.
On average, when small companies declare profits
which exceed the analysts' expectations, the price of their stocks, for the
next 12 months, overperform by 12,9 % the small capitalization security
index Russell 2000.
"The cockroaches' theory" can also be applied to the
small capitalization security sector. Indeed, 34 % of the companies which
reported unexpected positive profits during a first quarter repeat the
surprise during the next quarter. On the other hand, 41 % of the companies
which have declared profits lower than the expectations during a first
quarter repeat this bad surprise during the next quarter. However, the bad
surprise effect is not as catastrophic on the stock price, because on
average these companies underperform the basic index by 3,5 % during the
next year. Lastly, the industrial sectors where to find the most unexpected
profits declarations are those of the health care, the financial services,
the technology and the consumer products.