Figure 6-1 a

Price/Earnings All Surprises

Compustat 1500 1973 - 1996

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Surprise Quarter

FuU Year

I Low P/e Quintile □ Middle Quintiles □ High P/e Quintile

0% = Market Retum (3.6% quarterly, 15.6% annually) All figures are market adjusted.

estimate of the group of analysts following each stock as described in the last chapter. A surprise is measured against actual earnings, so it doesnt matter whether the eamings are up or down. If a company reports a loss of 80 cents a share, as an example, and the Street expected a loss of one dollar a share, then it would be considered a positive surprise of 20 cents divided by the 80 cents reported or 25%.

Do su rises impact favored and unfavored stocks in the same way? To find out well look at the combined effect of positive and negative su rises-on both groups. The results are shown in the Figures 6-1 a, 6-lb, and 6-lc. In each, the 20% of stocks most out of favor by one of the three value measures-price-to-eamings (6-1 a), price-to-cash flow (6-lb) and price-to-book value (6-lc)-are depicted by the dark bar, the 60% of stocks in the middle groups by gray, and the most favored 20% in white. The charts calculate the retum above or below the markets for each of the 95 quarters of the study.

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Figure 6-lb

Price/Cash Flow All Surprises

Compustat 1500 1973 - 1996

Surprise Quarter

Full Year

I Low P/CF Quintile Middle Quintiles □ High P/CF Quintile

0% = Market Return (3.6% quarterly, 15.6% annually) All figures are market adjusted.

The figures show the effect of an eamings 8 18 -measured in the quarter in which eamings were actually reported-which is almost always the quarter following that in which the income was eamed. We will call the quarter eamings are announced in the "8 8 quarter." The left-hand group ofbars shows the effect of the 8 8 in the quarter it was announced, while the right-hand group represents the effect after one year. The market itself is set at 0 in the center of the vertical scale on the chart. The 8 8 retum must be added to the market retum in each period to get the total retum. If a bar shows a 3% positive retum, for example, it means that it did 3% better than the market over this period of the study. The market provided a 15.6% retum on average, annually throughout the entire period. If it was a 3% negative return, it means it did 3% worse than the market. This type of chart lets you easily see how 8 8 affects each group of stocks.

Each of the charts shows at a glance that 8 8 helps unpopular stocks and hurts popular ones. Looking first at price/earnings ratios in Figure 6-la, we see that all 8 18 8 to unpopular stocks (positive and

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Figure 6-lc

Price/Book Value All Surprises

Compustat 1500 1973 - 1996

Surprise Quarter

Full Year

i Low P/BV Quintile Middle Quintiles □ High P/BV Quintile

0% = Market Return (3.6% quarterly, 15.6% annually) All figures are market adjusted.

negative combined) retum 1.5% above market in the su rise quarter over the life of the study. If, for example, the market was up 2.5% in the quarter (the average quarterly retum of stocks over the past 70 years), the most out-of favor stocks, as measured by the lowest 20% of P/Es, are up 1.5%, or 60% more than the market in the surprise quarter.

Beyond the su rise quarter, whats more, the beneficial or lethal effect of su rise increases. At the end of one year, the most out-of-favor stocks outperform the market by 4.2%. This nearly tripled the outper-formance of the market in the su rise quarter itself. Again, looking at the long-term rate of retum of stocks, the most out-of favor stocks outperform the market by about 41% annually. Remember, this is with positive and negative su rises combined, indicating that all su rises taken together very much favor stocks investors believe have lackluster prospects.

As Figure 6-la also shows, su rise works against stocks with the best expectations, in this case the 20% of stocks with the highest P/E multiples. This group unde erformed the market by 1% in the su rise