Smart Earnings & Equity Risk Premia

By Julien Messias, managing director portfolio manager, Uncia Asset Management

Article available on eqderivatives.com

In recent years, financial market practitioners have increasingly spoken about risk premia. Institutional
investors, mainly pension funds, are disappointed with hedge funds returns and especially the non-fulfilled
commitment of getting uncorrelated returns with respect to equity index returns versus high fees.
As a well-known statistic shows, on average, hedge fund performances could be replicated with systematic
short positions in a one-month 90% put on the SPX. As of today, the risk premia universe is delivering
persistent returns, but fees have been dramatically lowered compared to hedge funds, the ratio being from
almost 10 to 1. Within this innovative universe, very different systematic strategies can be found. One strategy,
called Smart Earnings is an example of a systematic strategy that can be explored by investors amid earnings
announcements.
POST EARNINGS ANNOUNCEMENT DRIFT (PEAD)
Many people have heard about the Post Earnings Announcement Drift effect, dating back to the famous
article by Ball & Brown, in 1968, An Empirical Evaluation of Accounting Income Numbers. If not, you can
find many articles related to earnings topics, one of the most interesting being the one by Skinner & Sloan,
Earnings Surprises, Growth Expectations, and Stock Returns or Don't Let an Earnings Torpedo Sink Your
Portfolio, in 2002, where they emphasize the huge effect of earnings days returns on the annual performance
of the stock, and where they challenge the famous Fama & French theory about the long term overperformance of value stocks versus growth stocks. It is definitely worth having a look!
SMART EARNINGS
Earnings periods are well-known to be the most volatile periods for a stock as assuming efficient market
hypothesis - it is when new idiosyncratic information is disclosed to the whole investment community.
First (bad) point: Earnings are gambling!..
It is quite funny to notice that many financial analysts are struggling to be as close as possible to the EPS,
EBITDA or any other fundamental characteristics. Investors are much more interested in knowing how the
stock price will react once the information has become public, and about forecasting this move instead of EPS
or EBITDA. Furthermore, a beat in EPS or EBITDA does not always mean good price reaction, as a miss does
not always mean a drop in price: accounting data are considered as past information already taken into
account in the price whereas what is important to investors is the guidance provided by the management,
the latter being forward information.

Surrounding the gambling behavior of earnings, below is a chart where the median somewhat equals the mean
at 0, the black curve standing for the stocks with PER<25, the red one for the others. More than 200,000
earnings over more than 12 years have been taken into account.
One can notice the huge leptokurtosis of the distribution, meaning that as a Sharpe focus asset manager, there
is no added value for your ratio to keep your stock position over the earning, as your expected return is zero
with a very high volatility.

Second (good) point: But investors behavioral biases create opportunities!

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Financial Analysts are laggards.

In big institutional investors, investment processes are very heavy
Inclusion or exit methods for indices usually indirectly depends on the stock recent performance

Given these assumptions, we have been developing a systematic methodology on the U.S. equity universe,
and especially the most traded ones: S&P500, Nasdaq100, Nasdaq Composite and Russell2000. Backtest
(with adapted and clean information filter, net from the traditional backtest biases: birth and death), out-ofsample and forward test show that the returns are really uncorrelated with the underlying indices.
Since Jan 3, 2003.

Since YTD:

We are about to compute the same study on DJ Stoxx 600 in Europe. Moreover, we plan to work on this
earnings effect, and to capture returns by using options. Both results should be available soon.
Should you be interested in our Smart Earnings method, or to discuss about earnings-related topics, feel free
to contact the author. Weekly reports are available on demand.
Momentum phenomenon is also very interesting topic and we are currently forward testing a proprietary tool.
This will feature in the next article from Uncia in EQDerivatives!