How much would you be willing to pay for a model that perfectly predicted the earnings of the companies in your portfolio? According to Professors Feng Gu and Baruch Lev of SUNY Buffalo and NYU Stern –not much.
In their recent article, “Time to Change Your Investment Model”, published in the Financial Analysts Journal, Gu and Lev illustrate that,
The average gains from investing in the companies that will meet or beat the consensus estimate continuously dropped from 6% in 1989-1991 to 2% in 2013-2015: a 67% return decrease!The stated return is over a 3 month period, assuming you predicted the earnings beat or hit 60 days before the earnings report and sold 30 days after. Since we do not have a perfect earnings prediction model available, we need to account for the occasional inaccurate prediction which could incur a loss, further eroding the maximum abnormal return of 2%.
But Why?
Gu and Lev assert that the loss of value in earnings prediction is due to a 40% drop of corporate investments out of tangible assets with a 56% investment increase into intangible assets since the early 1980s.
My question to you…
What does this mean for your investment approach? Do you even care? Let me know what you think in the comments below!
The article is talking about GAAP earnings specifically, which I can confirm that (at least in my coverage) no one cares at all about. Most companies report some kind of "operating," "adjusted," or "cash" EPS that investors do focus on. I guarantee people would pay for a perfect adjusted EPS prediction every quarter, which is really what analysts focus on in their models, at least in our models. The article makes a good point that accounting standards have not kept up with investment in intangibles. All my companies add back amortization to their earnings.
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