Many investors select stocks on the basis of companies’ earnings prospects. Since an efficient market will already have impounded these prospects in share prices, such investors will not outperform the market.
The authors derived forecast earnings per share growth for 1976 and actual EPS growth for 260 of the S&P companies for which the IBES service provides institutional earnings forecasts. Using the difference as a surrogate for change in the earnings forecast, they compared price performance over this period with both the magnitude of the original EPS growth forecast and the magnitude of the change. They found no relation between forecast EPS growth and actual price movement.
On the other hand, portfolios of companies whose consensus forecasts underestimated actual earnings growth outperformed the market on the average, whereas portfolios of companies whose consensus forecasts overestimated actual earnings growth underperformed the market. These results suggest that, if the objective of stock selection is achieving abnormal portfolio returns, selection must be based on anticipating changes in the consensus, rather than changes in earnings.
Institutions can increase the efficiency of their investment departments by using a two-stage selection process. First, analysts make preliminary forecasts of EPS growth, which are compared with consensus forecasts. Second, analysts concentrate on those companies for which the discrepancy between their forecasts and the consensus forecasts is greatest. In this way, analysts expend the bulk of their efforts on those firms most likely to offer exceptional share price performance.