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The Gurus Look for an Earnings Day Bounce

By: Validea
Posted: 4/20/2010 1:00:00 PM
Referenced Stocks: DLB;ESI;ISRG;UAM

In his book Contrarian Investment Strategies: The Next Generation , David Dreman says that the stock market is driven by surprises, and that one of the greatest sources of surprises is earnings reports. Dreman found that analysts' estimates of companies' earnings are rarely on the mark, but that Wall Street nevertheless gives their forecasts a lot of credence. That means earnings reporting days often result in reassessments of a company's prospects -- which can mean significant shifts in its stock price.

With first-quarter earnings season upon us, a big question is which stocks will get a bounce on earnings day, and which will take a hit. Of course, there's no way to know for sure, but Bespoke Investment Group recently offered some interesting research on the topic.

Bespoke compiled a list of the stocks that have, over the past decade, posted the best average one-day returns on earnings days . The biggest winner: Intuitive Surgical ( ISRG ), which has gained an average of 8.18% on earnings reporting days over the past 10 years.

After reading Bespoke's list I thought it would be interesting to see which of the earnings-day-bounce firms get approval from my Guru Strategies, each of which is based on the approach of a different investing great. To be clear, I don't think it's wise to invest in a company shortly before earnings day solely because it has strong past earnings day results -- a firm's fundamentals and financials are what matter most to me. But, if a company has the financial strength and fundamental soundness needed to pass one or more of my models, and has a history of earnings day bounces, it might present a chance to get a good stock with a bit of a potential bonus.

Interestingly, few of the stocks on Bespoke's list passed muster with my models. Here's a select few that do get high marks:

Dolby Laboratories ( DLB ): This San Francisco-based firm was a pioneer in the audio arena because of its noise reduction technologies. Today, Dolby licenses its technologies to companies that make such products as DVD players, computers, digital televisions, portable media devices, and gaming systems. Its products are also used by movie theaters and broadcasting companies.

Dolby, which is expected to announce first-quarter earnings in late April, has been a very strong performer on earnings announcement days over the past decade, averaging a 6.87% gain on those days. More importantly, the stock currently gets strong interest from my Peter Lynch-based Guru Strategy.

My Lynch approach considers Dolby a "fast-grower" -- Lynch's favorite type of investment -- thanks to its 39.5% long-term earnings per share growth rate. (I use an average of the three-, four-, and five-year EPS figures to determine a long-term rate.) To find growth stocks selling on the cheap, Lynch famously used the P/E/Growth ratio, which divides a stock's price/earnings ratio by its historic growth rate. The rationale: It's okay to buy stocks with higher P/Es, so long as they are producing sufficient growth. The model I base on Lynch's writings looks for stocks with PEGs below 1.0 (and preferably below 0.5).

Dolby is an example of a strong stock that might be considered too pricey based only on its P/E, which is currently about 29. But when you consider its stellar growth rate, the stock is still a good buy, according to this model, with a PEG of just 0.74.

Another reason this model likes Dolby: The firm appears to be very well financed, with a tiny 0.5% debt/equity ratio.

Universal American Corp ( UAM ): Universal American and its subsidiaries offer a variety of healthcare products, including traditional health insurance, Medicare managed care plans, and Medicare prescription drug benefits. The Rye Brook, N.Y.-based company's primary customer base is senior citizens. The firm, which is expected to announce earnings in late April, has averaged a 4.6% gain on earnings announcement days over the past decade, according to Bespoke.

There's been a lot of talk about how the new healthcare bill will impact Medicare-related firms, but Universal's shares have held up pretty well in the past couple months. My Lynch-based model thinks it's a bargain at its current price. It considers the firm a "stalwart" -- the type of large, steady firm Lynch found offered protection during downturns or recessions -- because of its 17% long-term growth rate and high ($5 billion) trailing 12-month sales. The firm's 9.7 P/E and that growth rate make for a PEG of just 0.57, easily passing the key Lynch model test.

Because financial companies inherently carry a lot of debt, Lynch didn't use the debt/equity ratio to gauge their financial health. Instead, he used the equity/assets ratio and the return on assets rate. The model I base on his writings looks for E/A ratios of at least 5%, and ROAs of at least 1%. At 38% and 3.66%, respectively, Universal blows those targets away.

Universal also earns extra points for passing one of my Lynch-based model's bonus tests -- net cash position. Lynch defines net cash as cash and marketable securities minus long-term debt; a high net cash/price ratio (above 30%) dramatically cuts down on the risk of a security. At 32.9%, Universal passes the test.

ITT Educational Services ( ESI ): This private education firm offers a variety of post-secondary degree programs, most of which focus on technology-related fields. Based in Indiana, it operates more than 100 technical institutes in 37 states, teaching more than 60,000 students. ITT has averaged an earnings day bounce of almost 5% over the past decade, according to Bespoke.

ITT gets high marks from two of my guru-based models, those I base on the approaches of Warren Buffett and Joel Greenblatt. My conservative Buffett-inspired model looks for firms that have consistently upped EPS over the past decade, and that have manageable debt, strong free cash flows, and high returns on equity. ITT has increased EPS in each year of the past decade, could pay off its $150 million in debt in about half a year given its $289 million in annual earnings, and has a free cash flow per share of $7.20, all of which are plenty good enough to pass muster with the Buffett approach. ITT also has generated a 39.4% return on equity over the past decade, a sign of both strong management and the durable competitive advantage Buffett is known to seek.

My Greenblatt-based model, meanwhile, is inspired by the remarkably simple two-variable approach that Greenblatt, a successful hedge fund manager, revealed in his Little Book that Beats the Market. This approach ranks all stocks by return on total capital and earnings yield, and looks for those with the best combined rankings. ITT's 11.91% earnings yield and excellent 147.27% return on total capital make it the 17th-best stock in the market, according to the Greenblatt-based model.

Disclosure: I'm long DLB, UAM, and ESI.