The New York Times-20080127-Outsmarting the Pack During Earnings Season

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Outsmarting the Pack During Earnings Season

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KNOWING a little bit more than the next guy is the name of the game on Wall Street. And during earnings season, now in full swing, betting correctly against consensus earnings forecasts may be a way to make some money, even in a turbulent market. Earnings that come in a penny or two above or below a forecast can often prompt wide -- and potentially lucrative -- swings in a stock price.

So it's little wonder that a cottage industry has grown around predicting earnings surprises. As many companies prepare to report earnings in coming weeks, forecasters at Citigroup Global Markets, Zacks Investment Research and StarMine have compiled lists of potential over- and under-achievers.

Citi, for example, expects Occidental Petroleum, Deere and Nvidia to exceed consensus forecasts. StarMine, a research firm in San Francisco that Reuters is acquiring, predicts that DreamWorks Animation will fall short of consensus estimates. And Zacks, in Chicago, predicts a positive surprise from Activision but disappointments from JetBlue Airways and Jones Apparel.

What makes these forecasters smarter than the consensus predictions they hope to outguess? Each says it has a special-sauce formula for assessing the likelihood of surprises. Citi, for example, heavily weights a company's history of exceeding or falling short of consensus forecasts. Companies that have experienced even one positive surprise are more likely to surprise again, explained Keith Miller, Citi's head of global quantitative research.

Other factors include recent trends in earnings revisions, as well as a stock's recent strength relative to the market.

Occidental Petroleum, which will report on Tuesday, and Deere, on Feb. 13, reported positive earnings surprises in the two previous quarters, Mr. Miller noted. Analysts have also been raising estimates on both over the last month. Nvidia, too, has reported positive surprises and has had good sales growth and widening profit margins, measures also heavily weighted by Citi.

Mr. Miller does not predict the magnitude of surprises -- just the direction. In December, Citi predicted five positive surprises (Synopsys, Goldman Sachs, Nike, IHS and UnitedHealth) and two negative ones (First Horizon National, Lennar). Five of the seven -- all but Lennar and UnitedHealth -- surprised as predicted.

But investors who hope to ride the coattails of such success should be aware that surprise-forecasting systems have limitations. For one thing, they are not always right. And even when they are, a stock may not respond as expected. If a positive earnings surprise is accompanied by disappointing comments about a company's future prospects, as was the case with Apple earlier this month, the stock may tumble. And as with Citi's positive-surprise picks in December, the stocks may rise only briefly, then fall if the general market is weak, as it has been for weeks.

Shares of Synopsys, for instance, rose on Dec. 7 to $27.38 from just over $25, after it beat consensus estimates. But with the market in free fall, the stock sold off and was below $24 by Jan. 8.

Some stock gains for companies with earnings surprises can come before the earnings announcement. Ideally, investors would make their move to buy or short a potential surprise two weeks ahead of the announcement, said Mr. Miller, who has compared the performance of positive and negative surprisers from two weeks before to four weeks after they reported results. In that six-week period, stocks that most exceeded earnings forecasts outperformed those with the biggest disappointments by nearly 8 percent, he said.

StarMine uses a system that evaluates analysts on their history of earnings forecast accuracy. So recent revisions by highly rated analysts weigh more heavily than those of mediocre ones. And stale older predictions are often dropped, said Tim Gaumer, its director of fundamental research.

In forecasting a negative surprise for DreamWorks, StarMine heavily weighted the views of Drew E. Crum, a Stifel Nicolaus analyst who recently lowered his quarterly estimate of DreamWorks' earnings to 66 cents a share, versus a consensus of 86 cents a share. Reached by telephone, Mr. Crum said the studio's Bee Movie has had disappointing domestic box-office figures, estimating revenue of $127 million versus his earlier expectation of $155 million. And DVD sales of Shrek the Third will also disappoint, he said. He expects that shipments of the DVD in its first four weeks of availability will be just half the number for its predecessor, Shrek 2, in the comparable initial period in 2004.

Despite lowering his forecast, he kept a buy recommendation on the stock, citing what he called reasonable valuation.

ALSO in the cross-hairs at StarMine is First Marblehead, a repackager of student loans. Mr. Gaumer cites the forecast of Matthew Snowling, the Friedman, Billings, Ramsay analyst, who expects First Marblehead to report a loss of $1.42 a share, worse than the consensus forecast of a loss of $1.12. But Mr. Snowling said the size of the loss was not the main issue for the company -- it's investor readiness to resume buying bonds backed by student loans. That market has frozen, keeping First Marblehead from closing an anticipated securitization deal late last year. But for now, with student loan delinquencies on the rise, Mr. Snowling sees no evidence of a thaw. He has a target price of $10 on the stock, which trades at around $14.

I have a negative outlook on the stock. But if the securitization market improves, my outlook will, too, he said.

At Zacks, Charles Rotblut, senior market analyst, looks at earnings history and the most recent analyst revisions. Activision, which sells the hit video games Guitar Hero and Call of Duty, has topped consensus estimates the last three quarters. Mr. Rotblut accords Activision a high probability of repeating when it reports on Feb. 7.

On the negative side, he said, the trucking company YRC Worldwide could be hurt by an industrywide glut of new trucks bought to beat the tighter engine emission control regulations that took effect last year. As a result, truckers now have little pricing power to offset rising fuel costs, he said. YRC will issue its earnings report on Friday.

Mr. Rotblut also said Jones Apparel could be hurt by a tough retailing environment and would be likely to disappoint in February.

JetBlue, which reports on Tuesday, has been facing higher fuel prices and has had lower load factors -- the percentage of seats filled with paying passengers -- in recent months than in the year-earlier periods. I think they are going to miss, Mr. Rotblut said.

[Illustration]PHOTO: A research firm predicts a negative earnings surprise for DreamWorks Animation, based partly on an analyst's view of DVD sales for Shrek the Third. (PHOTOGRAPH BY DREAMWORKS ANIMATION AND PARAMOUNT PICTURES)