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Cameron McLennan
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E-mail: cmclennan@samllc.com

An overview of the SAM LLC quarterly EPS reporting analysis.

What is this analysis?  - The analysis below focuses on the quarterly earnings reporting performance, better than expected (BTE), weaker than expected (WTE) or inline vs. the most recent consensus estimate) of our Long and Short 130/30 Alpha Extension strategy holdings.  The quarter identified in the analysis is that of the most recent calendar quarter, i.e. the analysis for the quarter ending 06/30/08 includes all Long and Short holdings that reported quarterly EPS results during the period 04/01/08 to 06/30/08, independent of the time period in which the earnings were generated.  Therefore, the majority of the earnings reported during the quarter ended 06/30/08 would be considered Q1’08 earnings results by companies and Wall Street.  Our interest, in this analysis, is what the latest EPS results were NOT when they were generated.  It is important to note that the earnings model used in our investment process DOES take into account the specific quarter in which earnings were generated and the impact of the results on future quarterly and full year earnings estimates.

Why do we monitor EPS reports?  The SAM Earnings model is a significant contributor to an individual stocks alpha score.  A primary role of the Earnings model is as a predictor of a company’s EPS results vs. the consensus estimate.  Our goal is to be Long companies that we expect to report BTE EPS results and to be Short companies that we expect to report WTE EPS results.  We expect, all other things being equal, the market to reward/punish the stock price of companies that report BTE/WTE EPS results.  Therefore, our goal is to have a greater percentage of our Long holdings report BTE EPS results vs. our Short holdings.  The wider the positive “spread” between the Long and Short holdings the more likely the performance of the portfolio will be positive. 

What do we expect to see?  Our Long holdings have higher Earnings model scores vs. our Short holdings.  Therefore, we expect to see our Long Holdings report BTE quarterly earnings results more frequently than our Short holdings and the market in general.   On average, our Long and Short holdings report BTE quarterly EPS results 70% and 56%, respectively, a +14% spread.  Note: For comparison, historically companies that comprise a broad market index such as the SP 500 have reported BTE EPS results 60% to 65% of the time.

PORTFOLIO EPS SURPRISE ANALYSIS – QUARTER END 06/30/08

1) A total of 96 holdings reported EPS during the calendar quarter (65 Long and 31 Short).  The percentage of Long holdings that reported Better Than Expected (BTE) EPS results was up slightly from the previous quarter and well above the 70% historical average.  75% of the Long holdings reported BTE EPS results, up from 72% in the calendar quarter ended 03/31/08.  Meanwhile, only 29% of the Short holdings reported BTE EPS results, which was well below the 56% average.  The net result was a whopping +46% Long vs. Short spread.  This is the highest spread that we have recorded and compares to the average spread of approximately +13%.  Note: For comparison, we estimate that companies that comprise the Russell 1000 index reported BTE EPS results 57% of the time this quarter. 

2) Continued below average performance in the Financial sector (50%), was more than offset by strong performance in the remaining sectors, lifting the overall performance of our Long holdings.  The issues affecting the operating performance of Financial companies are well documented.  The percentage of Financial companies that reported BTE EPS results remains well below its historically high levels (75% to 80%).  There were some indications that the worst was behind the sector heading into the past quarter.  Howover, this did not eventuate, i.e.. at the broad index level we estimate that the percentage of companies reporting BTE EPS results was less than 40%.  Offsetting the weak results in the Financial sector where BTE EPS levels at 100% in some sectors and 80%+ in other major sectors (measured by the number of companies that reported EPS results this quarter), Healthcare and Energy.   Weakness across most sectors pulled down the results of the Short holdings.  With Short positions comprising only 30% of the portfolio weight we can focus on those stocks with the greatest likelihood of reporting WTE results.  So far the results indicate that this is working.  The following is an overview of the Best and Worst sectors highlighting: (the number of reporting companies/the percentage of positive surprises).

3) What influenced the above average performance of the Long holdings?  After producing below average results in the initial quarters following the beginning of the sub-prime lending debacle, our Long holdings have now logged three quarters of better than average % BTE EPS results.  What has changed?  One factor that continues to work against the overall performance of the Long holdings is the reduction in the number of Financial companies that have managed to report BTE EPS.  Financials accounted for approximately 18% of the Long quarterly reports, therefore a drop from their historically high average of BTE EPS reports to the current level has had a meaningful impact on the overall performance of our Long holdings.  Fortunately, unlike in 2007 calendar quarters two and three, above average performance (80% BTE EPS results ex Financials) by the majority of the remaining sectors over the past three quarters has more than offset the Financial sector weakness.  A significant improvement in the y/y earnings growth in Financial and Consumer Discretionary sectors is forecast to begin in the Q3'08EPS reporting period.  This improvement is expected to coincide with slowing in sectors such as Energy as their y/y comparisons become more difficult to significantly outperform.

4) At least initially, the market rewarded/punished companies that reported BTE/WTE EPS results during the quarter.  In addition, on average, the direction of a companies EPS outlook vs. expectations compounded the positive/negative impact of the BTE/WTE EPS report.  On average, the one day performance of stocks (Long and Short) that report BTE/WTE EPS outperformed/underperformed their market adjusted expected return.  In addition, the one day (market adjusted) average return for Long holdings that reported BTE EPS results significantly outperformed Long holdings that reported WTE EPS results, +0.7% vs. -2.8%.  These results, were consistent for Short holdings that reported BTE/WTE EPS results, +0.5% vs. -5.1%.  Our longer-term studies show that stocks that report BTE EPS results, on average, will outperform (on a market adjusted basis) in the 20 trading days following the announcement date.  In addition, during this 20 day period we also have observed some improvement in the performance of stocks that reported WTE EPS results.  We believe that the relative improvement of these stocks is likely due to the reversal of some initial (one day) negative performance over-reactions.

5) Post earnings report negative pre-announcements significantly impacted company performance.  On average, the performance of stocks that followed a BTE EPS report with a positive pre-announcement outperformed stocks that followed a BTE EPS report with a negative pre-announcement by +460 bps (+3.0% vs. -1.6%).  This relationship is inline with our expectations and highlights the importance of company pre-announcements following the EPS report on the performance of our holdings (and portfolios).  Unlike our EPS reporting analysis that includes all reports during the period, not all companies provide guidance or update their guidance immediately following their EPS report.   Therefore, the pre-announcement results presented here are based on a smaller sample size than our EPS report analysis.  The results include a broad range of companies and could therefore be reasonably assumed to be representative of the larger universe, in our opinion.

6) Although it was not the case this quarter, in general, we expect the average performance of Short holdings to outperform Long holdings subsequent to reporting BTE or WTE EPS results.  Why? The rationale behind our performance expectation is that we believe investors' ex ante EPS report expectations are higher for the Long holdings than for the Shorts.  Therefore, the risk/reward profile is often skewed against the Long holdings, i.e. higher expectations and possibly stronger relative performance ahead of the report date vs. our Short holdings, which on average should exhibit the opposite characteristics.  With this in mind, we believe that it is important that a significantly greater percentage of the Long holdings report BTE EPS results vs. the Short holdings.  In an effort to identify market ex ante expectations we compare the average (market adjusted) performance of the Long and Short holdings in the 4 weeks (20 trading days) prior to their EPS release.  The results of this analysis are inline with our assumptions regarding investor pre-release expectations: on average, the performance of our Long holdings during this period is greater than for our Short holdings.  In addition, the relative performance of Long and Short holdings that reported BTE/WTE EPS results is higher/lower than the pre release performance of the respective averages.  

Note:  The universe used for this analysis is comprised of Long/Short positions held in SAM's 130/30 strategy.