Pulling the Trigger

Regardless of which valuation method was used, when earnings came in above analysts forecasts on out-of-favor stocks, they shot out the lights. Just as apparent was the sharp unde erformance of the winners, the top 20% of stocks as measured by price-to-earnings or price-to-cash flow ratios, when analysts estimates were too optimistic.

What the study shows, then, is that the overvaluation of "best" stocks and the undervaluation of "worst" stocks is often driven to extremes. That brings us quite naturally to Rule 11:

RULE 11

Positive and negative surprises affect "best" and "worst" stocks in a diametrically opposite manner.

People are far too confident of their ability to predict complex outcomes in the future. This was shown to be true in many fields from medicine and law to mediation. The stock market, with thousands of constantly shifting company, industry, economic, and political events, certainly ranks among the most formidable areas in which to make forecasts.

Good or bad news, which occurs frequently in markets, results in diametrically opposite movements of "best" and "worst" stocks. When we recall that money managers are considered "stars" if they can outperform markets by 2% or 3% annually over a 5-year period, the 4.1% annual outperformance ofthe "worst" stocks after all 8 18 8, as measured by price-to-cash flow (shown in Figure 6-lb, with similar results

rors by analysts and their noted overoptimism-9% annually in one landmark study-is lethal for buyers of favorite stocks.

Finally, Figure 6-3a shows the expected: negative 8 8 8 have more effect on the 60% of stocks in the middle group than on the low price-to-cash flow stocks, but far less than on the high price-to-cash flow group for both the 8 8 quarter and the year. But this is almost entirely offset by their outperformance with positive 5 8 8. In fact, as Figures 6-la, 6-lb, and 6-lc, indicate, when positive and negative surprises are put together, they have almost no effect on the middle groupings. Overall, they are a nonevent for this 60% of stocks. All the findings behind the charts in this chapter are statistically significant.

in 6-la and 6-lc), coupled with the 3.2% underperformance of the "best," is an enormous differential. The disparity, of course, is firmly anchored on investor overconfidence of pinpointing future events. We see then that surprise has an enormous, predictable, and systematic influence on stock prices.

Loolcing more carefully at the charts we also can see that earnings surprises cause two distinct categories of price reactions in both "best" and "worst" stoclcs. The first Ill call an event trigger, and the second, which will be discussed shortly, a reinforcing event.

I define an event trigger as unexpected negadve news on a stock believed to have excellent prospects, or unexpectedly positive news on a stock believed to have a mediocre outlook. The event trigger results in people looking at the two categories of stocks very differendy. They take off their dark or rose-colored glasses. They now evaluate the companies more reaUstically, and the reappraisal results in a major price change to correct the markets previous overreaction.

There are two types of event triggers. The first is a negative surprise for a favored company, which will drive its stock price down. The second is a positive su rise for an unfavored stock, which pushes its price much higher. The event trigger initiates the process of perceptual change among investors, which can continue for a long time. As has been shown, the process goes on beyond the quarter in which the surprise is reported and through the year following the su rise. In the next secdon, well see it condnues for much longer periods.

Event triggers can result from su rises other than earnings. A non-earnings su rise might be the approval by the FDA of an important new drug-or its denial of further testing. Winning or losing a landmark tobacco case would be another. New technology that suddenly obsoletes an important semiconductor would be a third. There could be hundreds of such su rises, any one of which could have a 8 and lasting impact on a stocks price. Although not tested as yet, observation suggests that the impact of such su rises on stock prices would be similar to the impact an eamings su rise has had on the best, worst, and middle groups.

Event triggers are most frequendy activated by eamings su rises, however. The first type of event trigger is a negative su rise on a highly regarded company. An example is the 1992 eamings 8 8 that felled high-flying U.S. Surgical. At the time, it was the largest manufacturer of laparoscopic surgical equipment. Laparoscopic surgery, as you probably know, enormously reduces the dangers of surgery and the time of recovery. It was a rapidly growing medical area with exploding earnings

and an exciting story. The stock soared, trading as high as $108 late in 1992. It then had a number of disappointing earnings su rises and dropped as low as $17 the following year.

Investors now saw not only disappointing eamings, but also rapidly increasing competition from Johnson & Johnson, a slow-down in anticipated growth in the laparoscopic market, and serious questions about the companys senior management. With the strong market and some recovery in eamings, the company has risen to $29 in late 1997, a little over one-third of its previous high. The event trigger resulted in a major and permanent reassessment of the company by investors.

As we saw, investors systematically overrate the futures of such companies. When a negative eamings 8 8 occurs, people are stunned by news on "best" stocks. Their reaction is to sell-fast!-sending the prices down, often dramatically.

The second type of event trigger is a positive 8 8 -or a series of positive 8 8 8-for an out-of-favor stock. Investors do not expect positive 8 8 8 from companies they consider to have poor outlooks. When they happen, people begin a process of perceptual change. The stocks are reevaluated more positively, and they outperform the market significantly, largely because of the original undervaluations.

Dell Computer, a manufacturer of desktop and notebook computers, is a good example of an event trigger on an out-of-favor stock. The company traded as low as $1% in 1993 on a disappointing outlook. Eamings in 1994 came in above forecast for a number of quarters and the stock reacted strongly. By November of that year it more than tripled, rising to $6%, and continued to move up to $103 by October of 1997.

Investors perceptions about a company, an industry, or the market itself often do not change with a single positive or negative 8 8 . Jeffrey Abarbanell and Victor Bemard of the University of Michigan, for example, have studied analyst estimates and find they have been slow to adjust to eamings su rises. Whether the estimate was too high or too low, analysts do not revise them accurately immediately, but take as long as three quarters after the 8 8 to do so.* When the forecasts are too high, they continue to be high for the next nine months, and when they are too low, they continue to be too low for the next three quarters.

As Abarbanell and Bemard put it, analysts "underteact to recent earnings reports." This underteaction generates new 8 8 8, which reinforce investors changing opinion of a company. If, for example, investors are taken aback by a negative eamings su rise on a favorite stock, and more negative 5 8 8 occur in the following quarters (as a result of analysts not revising eamings down enough), peoples increas-