Chapter 9

Nasty Surprises and Neuroeconomics

HISTORY IS REPLETE with unheeded alarm bells and dreadful surprises. Almost a hundred years ago, in 1915, the German embassy took out an ad in The New York Times. It warned U.S. citizens that they risked torpedo attacks on Allied passenger ships. The United States had not yet entered World War I. (In fact, President Woodrow Wilson would successfully run for reelection on the slogan “He kept us out of war.”) Yet when the British ocean liner Lusitania left New York bound for Liverpool, many American passengers were on board, along with 173 tons of rifle ammunition and shells for the British army. A German submarine attacked the ship off the south coast of Ireland, causing the loss of 1,198 passengers and crew, including 114 Americans. Although the ship was a legitimate target under international law, many Americans were outraged at the “surprise,” and public sentiment began to tilt against Germany. Two years later, the United States was in the war on the side of the British.

Twenty-six years later, the United States was surprised again. This time it was Pearl Harbor. The Japanese sneak attack on the military naval base in Hawaii catapulted the United States into World War II. Decades later, the evidence is fairly conclusive that in 1941 there were plenty of warning signs of what the Japanese navy intended. (Interestingly, it seems that many U.S. military leaders felt that the “inferior” Japanese people could never pull off such an attack.) That surprise also galvanized and unified a nation still reeling from the Great Depression and the widespread fears of civil strive, anarchy, and communism.

Knowing history, some twenty-three years later President Lyndon Johnson informed the American public of yet another complete surprise. To whip up support for a major escalation of the Vietnam War, in 1964 he greatly exaggerated the report of an attack on a U.S. destroyer in the Gulf of Tonkin. North Vietnamese torpedo boats had supposedly attacked the USS Maddox without provocation or cause. (Few knew at the time that the previous day the South Korean navy, under U.S. direction, had carried out clandestine raids on nearby North Vietnamese islands or that the destroyer had been on an intelligence mission.) Reacting to the announcement, Congress immediately handed the president the sweeping powers he requested and a blank check for the war.

Not unexpectedly, Congress’s “buyer’s remorse” at the actions it authorized would rival that of any investor caught up in a very nasty market surprise. Patriotic emotions had again swept aside more reasoned considerations—yes, shades of Affect—and had momentous consequences. As history bears out, warning signs may not be seen clearly during the moment, but nasty political surprises can almost predictably lead to overreactions by officeholders and the general public alike.

In the markets, investors also react to surprise in a fairly predictable way. In the 2000s alone, the collapse of Enron in 2000–2001, followed by that of WorldCom in 2002 and then Bernie Madoff in 2008, soured millions on stocks. The distrust has been heightened by the flash crash of May 6, 2010, in which the Dow Jones Industrials dropped more than 600 points in minutes and the intraday swing was over 1,000 points, the second largest in market history. At the time of this writing the SEC and CFTC still have not taken appropriate action to prevent another flash crash from occurring; their inaction has further disillusioned investors and resulted in a flood of cash pouring out of stocks into Treasury bonds at almost zero yields.

That’s what surprises do on Wall Street. They continually change our outlook on owning bonds or stocks or gold. Within the stock market they do the same for companies’ earnings outlooks—and thus inevitably their stock prices. The market is always adjusting to surprises or anticipating them or discounting them: the standard fare of investment news you hear or read every day. The key players, of course, in initiating a market surprise are the analysts we met in the previous chapter, the men and women who predict what will happen barring any surprise. Ironically, here we have a self-fulfilling prophecy. It’s their pinpoint forecasts, which are rarely met, that create the majority of earnings surprises on stocks.

After covering the many aspects and systematic patterns of surprise in this chapter’s first section, the last part of the chapter will introduce a relatively new field of science dubbed “neuroeconomics,” which breaks down some traditional boundaries. This field combines research from neuroscience, psychology, and economics to analyze how people make decisions. It catalogs the inner activity of the brain using advanced monitoring technology to spot what actually happens when we evaluate decisions, categorize risks and rewards, and interact with other people. In short, one of its aspects is an objective, biologically based extension and confirmation of important findings in cognitive psychology. The results are often surprising!

Surprise and the Market

Time to think twice about that stock purchase? Possibly. But far more important, maybe it’s time to reconsider the whole mechanism of surprises, not simply from an anecdotal perspective but from a solid statistical basis. Yes, negative surprises have enormous influence on us, both as citizens and as investors. But there is the other and far more upbeat side of the coin: positive surprises put spring in our step and add heft to our portfolios. In this chapter we will look at earnings surprises. Although, as we just saw, they occur frequently, they don’t necessarily have to be anxiety-producing events. Quite the opposite; if you know what you’re looking for, they can bring up some very cheery days. We’ll see that earnings surprises have a consistent and predictable effect on stock prices that you can use to your advantage.

Specifically, they have a dramatically different impact on stocks that people like as contrasted to those people don’t like. Importantly, the new and rapidly growing field of neuroeconomics uses brain scans to study some of our major emotional reactions to surprise, providing a solid explanation of what we shall see. And understanding the nature of surprises provides a high-probability method of beating the market.

Surprise: No Price Is Too High for Growth

At times, no price seems too high for aggressive growth stocks or IPOs. Investors repeatedly pay through the nose and just as repeatedly get stung. Nevertheless, as we’ve seen, strong psychological forces compel people to buy sizzling issues and then prevent them from analyzing where they went wrong.

The pattern is, not unexpectedly, repeated for larger companies. Investors believe they can forecast the prospects for both exciting and unexciting stocks well into the future. They have high hopes for “best” stocks and high confidence that their expectations will be met. Similarly, they have low expectations for stocks that appear to have lackluster or poor prospects but again high confidence that their estimates will be dead-on. The previous chapter showed just how dead-on such forecasts actually are.

Companies with the best prospects, fastest growth rates, and most exciting concepts normally trade at a high price relative to earnings (P/E), high price to cash flow (P/CF), and high price to book value (P/BV), and invariably provide low or no dividend yields. Conversely, stocks with poor outlooks trade at low price to earnings, price to cash flow, or price to book value and usually have higher dividend yields.*52

Often, the disparity between what investors will pay for a favored stock and one badly out of favor is immense, as chapters 1 and 2 showed. Investors, for example, happily shelled out 100 times more for each dollar earned by the Internet wunderkind eToys.com, shortly before it went to dot-com heaven, than for a dollar earned by boring old JPMorgan Chase. Investors pay such price differentials because of their confidence in their ability to pinpoint the future. Let’s look at what happens when—surprise!—their forecasts miss the mark.

Surprise: What Our Studies Revealed

To find out how stocks react when analysts err, I did a number of studies in collaboration with Drs. Eric Lufkin, Vladimira Ilieva, Nelson Woodard, Mitchell Stern, and Michael Berry over time, the latest one for the thirty-eight years ending with 2010.1 To be consistent, we worked with exactly the same analysts’ consensus forecasts that were used to calculate analysts’ errors in the preceding chapter.

We wanted to measure a number of factors important to investors. First, what do analysts’ forecasting errors do to stock prices? Second—and as important—do earnings surprises have the same impact on favored as on unfavored stocks? Stocks trading in outer space are there because of analysts’ confidence in their future—possibly mixed with a wee dose of overoptimism. Did they react the same way to earnings surprises as to stocks that are in the investor doghouse? Third, we wished to examine just how accurate investors expect analysts’ forecasts to be. To help resolve this, we measured how even tiny surprises affect a stock’s price by considering any amount over one penny a share a surprise.

To answer the three questions, we analyzed the stocks strictly according to how exciting or dull investors believed their prospects were, using three different value measures: the price-to-earnings, price-to-cash-flow, and price-to-book-value ratios. The higher the three ratios, the more enticing the stock is to an investor and the more he or she is willing to pay. Conversely, the lower the three ratios, the more unpopular the stock. We divided the stocks in all of the quarters in our 1973–2010 study into three groups strictly by how they ranked by each of these three value measures. The 20 percent of stocks that had the highest P/Es, for example, were placed in the top P/E group (called a quintile), the next 60 percent in the middle group, and the lowest 20 percent in the bottom quintile. We did this for all three value measures. The portfolios were reassembled on this basis for every quarter in the study. We then calculated the effect of surprises on each group of stocks beginning in the first quarter of 1973 and ending in the fourth quarter of 2010, a thirty-eight-year period in all.2

The study used the 1,500 largest companies in the Compustat database with fiscal years ending in March, June, September, and December.3 Approximately 750 to 1,000 large companies were used in each of the 152 quarters of the study.

Surprise: What the Historical Record Shows

Next we set a yardstick to gauge the result of market surprises. The surprises are measured against the analyst consensus forecast, the average estimate of the group of analysts following each stock, as described in the preceding chapter. A surprise is measured against actual earnings, so it doesn’t matter whether the earnings are up or down. If a company reports a loss of 80 cents a share, as an example, and the Street expected a loss of one dollar a share, then it would be considered a positive surprise of 20 cents divided by the 80 cents reported, or 25 percent.

Do surprises affect favored and unfavored stocks in the same way? To find out, we’ll look at all surprises, the combined effect of positive and negative surprises on the favorite stocks—the highest quintile—the middle quintiles, and the out-of-favor stocks—the lowest quintile. The results are shown in Figures 9-1, 9-2, and 9-3. In each case, the 20 percent of stocks most out of favor by one of the three value measures—price to earnings (9-1), price to cash flow (9-2), and price to book value (9-3)—are depicted by the dark bar, the 60 percent of stocks in the middle groups by gray, and the most favored 20% by white.4 The charts calculate the return above or below the market’s for each of the 152 quarters of the study.

The market return*53 is set at 0 in the center of the vertical axis of the chart. The surprise return must be added to the market return in each period to get the total return. If a bar shows a 1 percent positive return on the left, for example, it means that the stock did 1 percent better than the market over the average three-month return of the study. The market provided a 3.5 percent return on average, quarterly, so the total quarterly return would be 4.5 percent (the market return plus 1 percent or 4.5  percent for the average quarter throughout the study). If the stock did 1 percent better for the full year, it would return 14.8 percent, as shown in the chart, plus an additional 1 percent, or 15.8 percent for the full year on average, annually, throughout the entire study. If it was a 3 percent negative quarterly return, it did 3 percent worse than the market. This type of chart lets you easily appraise how surprise affects each group of stocks.

The figures show the effect of an earnings surprise, measured in the quarter in which earnings were actually reported—which is always the quarter following that in which the earnings surprise took place. We will call this latter quarter the “surprise quarter.” The left-hand group of bars shows the effect of the surprise in the quarter it was announced, while the right-hand group represents the effect after one year.

A glance at each of the charts shows that all surprises (positive and negative combined) helped unpopular stocks and hurt popular ones. Looking first at price-earnings ratios in Figure 9-1, we see that all surprises to unpopular stocks returned 1.2 percent above the market’s return in the surprise quarter over the life of the study, about a third more than the market.

What’s more, beyond the surprise quarter, the beneficial or lethal effect of a surprise increased for the full year. All surprises for out-of-favor stocks (the low-P/E group) returned an average 3.8 percent above market each year. This is 26 percent annually above the market return over the life of the study. It is also triple their outperformance in the surprise quarter itself. By contrast, as the figure shows, favorite stocks, in this case the 20 percent of stocks with the highest P/E multiples, had a return almost 1 percent below the market in the quarter, which widened to 3.2 percent annually on average for the entire study, some 25 percent under the market return.

Surprise, as we might expect, did not seem to have much effect on the 60 percent of stocks that make up the middle grouping. These stocks are not normally over- or undervalued much. As Figure 9-1 shows, the stocks were down by less than one-third of 1 percent in the surprise quarter. A year after the surprise there was a small negative (–1.2 percent) effect.

However, the difference in the effects of all surprises on “best” and “worst” stocks was large and increased over time. “Worst” stocks outperformed “best” stocks by 2.1 percent in the surprise quarter, then steadily rose to 7.0 percent (or approximately 50 percent of the market return) in each year of the study.

To summarize, Figure 9-1 reveals that earnings surprises did not affect the returns of the various P/E groups the same way. Surprise significantly benefits unfavored low-P/E stocks and works against the high-P/E group, while it has a nominal effect on stocks in the middle group. Is there any difference in how surprise affects stocks ranked by the other value measures?

Surprise: Toute la Différence

Figure 9-2 looks at the effects of all surprises on stocks measured by price to cash flow. The chart is nearly identical to Figure 9-1 for the surprise quarter and the full year. The lowest-price-to-cash-flow group again strongly outperformed the market in both cases. Similarly, the favorite stocks, the 20 percent of highest-price-to-cash-flow issues, significantly underperformed the average in both periods, while the middle group was almost unaffected by surprises. By this value measurement, surprises in analysts’ forecasts once again work powerfully in favor of the most unwanted group and against the most highly regarded stocks.

Figure 9-3 demonstrates the effects of all surprises measured by price to book value. Remember, the higher the price-to-book-value ratio, the more popular a stock is, and the lower this ratio, the less popular the stock is. Again, the results are similar. Favorite stocks underperformed in the surprise quarter (–0.7 percent) and did even worse for the full year (–2.8 percent). Unpopular stocks outperformed in the quarter (+0.7 percent) and took off nicely over the full year (+2.9 percent above market). Again, the middle 60 percent of stocks were far less affected by earnings surprises.

What is remarkable is not only that out-of-favor stocks outperformed by all three measures but how similar the performance was regardless of the value measure we chose. We thus begin to see a path to making money in the stock market. Earnings surprises, whether positive or negative, affect favored and out-of-favor stocks very differently. Surprise consistently results in above-average performance for out-of-favor stocks and below-average performance for favored stocks. Has the lightbulb gone on? We can find illumination in this Psychological Guideline.

 

PSYCHOLOGICAL GUIDELINE 18: Earnings surprises help the performance of out-of-favor stocks, while affecting the returns of favorites negatively. The difference in returns is significant. To enhance portfolio performance, you should take advantage of the high rate of analysts’ forecast error by selecting out-of-favor stocks.

Conversely, buying favorites will cost you money. How much money? A look at the magnitude of the surprise effect is sobering, as I’ll demonstrate shortly.

The Effects of Positive Surprises

In the preceding section we looked at all surprises, both positive and negative combined, for three of the major fundamental yardsticks, the price-to-earnings, price-to-cash-flow, and price-to-book-value ratios. In this section we will separate the surprises and look first at how positive surprises—higher-than-expected earnings—effect each of the above fundamentals.

Examine Figure 9-4. It shows the effects of positive surprises on stocks in our high, low, and middle groupings, by P/E. As you can see, positive surprises galvanize the lowest 20 percent of stocks. In the surprise quarter, they outperform the market average by 2.6 percent, or 75 percent. For the full year, the lowest P/E quintile charges ahead of the market by a remarkable 6.7 percent annually on average through the 1973–2010 period, returning 21.5 percent. Think about that for a moment. Since the mid-1920s, stocks have returned about 9.9 percent annually.5 Owning out-of-favor stocks that have positive surprises will fetch you almost double the broad market return over time. We’ll look at the reasons for this astonishing increase in return shortly.

Positive surprises also have a noticeable but more subdued effect on stocks in the middle quintiles. The middle group outperformed the market by 1.4 percent in the same quarter. But the above-market return stayed the same for the remaining nine months. The stocks don’t continue to appreciate steadily. The price impact due to positive surprises is moderate, probably because they are the least under- or overvalued.

Finally, positive surprises have far less effect on favorite stocks. Stocks that experience positive surprises outperform the market by 1.1 percent in the surprise quarter. The “best” stocks don’t keep improving, however, as do those in the low-P/E group. Rather, they lose about half of their small gain over the next nine months.

Although not shown, the lowest 20 percent of stocks ranked by price to cash flow or price to book value are remarkably similar. Both sharply outperformed the market for the surprise quarter and for the full year and routed the most favored stocks for the two periods. The result for the 60 percent of stocks in the middle quintiles is close to those of the other middle groups in the previous charts.

Why do positive surprises for “best” stocks cause only a moderate rise in the surprise quarter? Since analysts and investors alike believe that they can judge precisely which stocks will be the real winners in the years ahead, a positive surprise does little more than confirm their expectations. It’s no great shakes—the top companies are expected to have rapidly growing revenues, market share, and earnings. By the end of the year, therefore, the effect of the surprise is minuscule. As we’ll soon see, some recent neuroeconomic findings seem to explain why there are these various reactions to surprise by the favored, out-of-favor, and middle groups.

Investors react very differently to positive surprises for out-of-favor companies, no matter which of the three value yardsticks we measure them by. Those stocks moved into the lowest category precisely because they were expected to continue to be dullards. They are the dogs of the investment world and investors believe they deserve minimal valuations. A positive earnings surprise for a stock in this group is an event. Investors sit up and take notice. Maybe, they think, these companies are not as bad as analysts and investors believed. The prices of out-of-favor stocks, therefore, do not just move up in the quarter of the surprise and then drop back again, as do those of the favorites. Instead, they continue to move steadily higher relative to the market in the year following the surprise.

We have seen three distinctly different reactions to earnings surprises by the high, low, and middle stock groups using three of the most important value measurements. However, as with the weather, not all days can be sunny and not all news can be good. Negative surprises, which normally send chills down investors’ spines, are the other side of the coin we need to examine.

The Effects of Negative Surprises

Figures 9-5 and 9-6 show the effect of negative surprise on the “best,” “worst,” and middle groups by price to cash flow and price to earnings. Out-of-favor stocks again win in a breeze. Let’s start by looking at price to cash flow (Figure 9-5). Negative surprises in analysts’ forecasts have a minimal impact on the lowest 20 percent of stocks in the surprise quarter, and as a result this group falls below the market by only 3/10 of 1 percent. Moreover, the market shrugs off the surprise by the end of the year, with the lowest-price-to-cash-flow group outperforming the market by 1.3 percent. (The results for price to book value are similar but are not shown here.)

Negative surprises are like water off a duck’s back for this out-of-favor group. Investors have low expectations for what they consider lackluster or bad stocks, and when these stocks do disappoint, few eyebrows are raised. The bottom line is that a negative surprise is not much of an event in the surprise quarter and is a nonevent in the nine months following.

Consider the “best” companies, however. Investors expect only glowing results for these stocks. After all, they confidently—overconfidently—believe that they can divine the future of a “good” stock with precision. These stocks are not supposed to disappoint; people pay top dollar for them for exactly this reason. So when a negative surprise arrives, the results are devastating.

Figure 9-5 shows how the “best” stocks, by price-to-cash-flow ratio, reacted to negative earnings surprises. In the quarter in which investors received the news, the stocks underperformed the market by a startling 3.6 percent on average. They did 12 times as poorly as the lowest-price-to-cash-flow group when receiving “bad” surprises. Worse yet, whereas the most out-of-favor stocks outperformed the market slightly in the next nine months, the favorites continued to drop. At the end of the year, they were 9.4 percent under the average. Favorite stocks with negative surprises underperformed the market’s return of 14.8 percent by a shocking 64 percent annually, on average, over the thirty-eight years of the study. As Figure 9-5 also shows, the lowest-price-to-cash-flow group outperformed the highest by a remarkable 10.7 percent in years when both groups suffered negative surprises.

Figure 9-6, which measures negative surprises by price-earnings ratio, shows similar results. Negative surprises on the highest 20 percent of P/Es cause the stocks to drop sharply in the surprise quarter; this drop is followed by a larger decline in the next nine months.

What do we make of numbers like these? It’s apparent that investors are shaken when companies they expect to excel disappoint. The disappointment does not have to be large. You may remember that we purposely used a very small analyst forecast error—one cent and over—to see how precise estimates have to be. From the major declines of high-visibility stocks on even nominal forecast errors, it’s obvious that the pinpoint accuracy demanded of earnings forecasts should not play a major role in valuing a stock. Yet, as we have seen, it’s at the heart of security analysis practiced today. A pilot would not use a GPS in his plane that could only get him accurately to within some hundreds of miles of his destination, yet he is quite comfortable using a financial GPS that does just that.

We saw in the previous chapter (Table 8-3) that the probability of avoiding a negative surprise of more than 5 percent was 1 in 62 for ten quarters and 1 in 3,800 for twenty quarters. The current study indicates that investors’ tolerance for negative surprises on popular stocks is much lower than this. Considering the devastating effects of negative surprises on favorite stocks, these are odds no rational person should want to face.

Too, we saw in the preceding chapter that analysts are, on the whole, overoptimistic in their forecasts. The combination of analysts’ noted overoptimism and their large forecast errors—in one landmark study the error was 9 percent annually—is lethal to buyers of favorite stocks.6

Finally, Figures 9-5 and 9-6 show the expected: negative surprises have more effect on the 60 percent of stocks in the middle group than on the lowest-price-to-cash-flow stocks but far less than on the highest-price-to-cash-flow group for both the surprise quarter and the year. But this is mostly offset by their outperformance with positive surprises. Figures 9-1, 9-2, and 9-3 show very similar results. All the findings behind the charts in this chapter are statistically significant.7

The Effects of Event Triggers

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

What the study shows, then, is that the overvaluation of “best” stocks and the undervaluation of “worst” stocks are often driven to extremes. That brings us quite naturally to the next Psychological Guideline.

 

PSYCHOLOGICAL GUIDELINE 19: 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 has been shown to be true in many fields from medicine and law to building new plant facilities. The stock market, with its thousands of continually 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 percent or 3 percent annually over a five-year period, the 3.4 percent annual outperformance of the “worst” stocks after all surprises, as measured by price to cash flow (shown in Figure 9-2, with similar results in Figures 9-1 and 9-3), coupled with the 3.6 percent underperformance of the “best,” or 7.0 percent total outperformance of low-P/E over high-P/E stocks, is enormous. The disparity, of course, is firmly anchored in investors’ overconfidence in pinpointing future events. We thus see that earnings surprises have an enormous, predictable, and systematic influence on stock prices.

Looking carefully at the charts, we can also see that earnings surprises cause two distinct categories of price reactions in both “best” and “worst” stocks. I’ll call the first an “event trigger” and the second, which will be discussed shortly, a “reinforcing event.”

I define an event trigger as unexpected negative news about a stock believed to have excellent prospects, or unexpectedly positive news about a stock believed to have a mediocre outlook. As a result of the event trigger, people look at the two categories of stocks very differently. They take off their dark or rose-colored glasses. They now evaluate the companies more realistically, and the reappraisal results in a major price change to correct the market’s previous overreaction.

THE FIRST EVENT TRIGGER

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 surprise 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 surprise. In the next section, we’ll see that it actually continues for much longer periods.

Event triggers can result from surprises other than earnings. A non-earnings surprise might be the FDA’s approval 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 makes a semiconductor obsolete would be a third. There could be hundreds of such surprises, any one of which could have a sharp and lasting impact on a stock’s price. Although the idea has not yet been tested, observation suggests that the impact of such surprises on stock prices would be similar to the impact earnings surprises have on the best, worst, and middle groups.

Event triggers are, however, most frequently earnings surprises. The first type of event trigger is a negative surprise on a highly regarded company. An example is the free fall in the price of Amgen, the world’s largest independent biotech medical company, which has a strong product line for the management of cancers and other serious diseases. Its major products were Aranesp and Epogen to treat anemia in cancer patients. The company added another promising drug for cancer, Vectibix, in 2006. Amgen showed outstanding earnings growth from 2002 through 2005, and the stock price moved from $57 in early 2005 to $86 later that year owing to its earnings, strong product line, and promising pipeline of potential new drugs. Analysts continued to increase their earnings forecasts for the stock.

Then the roof fell in. In late 2006, the company, in attempting to further expand its market for Aranesp, found that the mortality rate, always a concern with this drug, was slightly higher in a new study than in previous ones. Significant concern was expressed by leading oncologists, and recommendations were made to decrease the allowable dosage or possibly ban the drug entirely, which shocked both analysts and investors. Earnings estimates were cut well below the prior exuberant forecasts for a number of quarters, and the stock was downgraded by many on the Street. The price of Amgen plummeted 54 percent by March 2008.

The doomsday scenario analysts painted did not turn out to be nearly as bad as thought. The FDA mandated additional warnings on Arenesp’s labeling and moderate downward adjustments in dosages were made, but the drug continued to be a major profit center. Earnings growth began to accelerate in 2008 and was up again in 2009. But the luster was gone. By the fall of 2010, Amgen was no longer considered a “favorite stock.” Trading at a P/E of 10х, it was now relegated to the “worst-stocks” category.

The event trigger resulted in a major reassessment of the company by investors. As we saw, investors systematically overrate the future of favored companies. When a negative earnings surprise occurs to a favored stock, accompanied by serious downbeat news, people are shaken by the realization that this could happen to a “best” stock. Their reaction is to sell—fast—sending the prices down, often dramatically. Even when the bad news proved to be not nearly as severe as originally anticipated and the company, in fact, came near to meeting its original earnings targets, the memory of the unpleasant experience lingered. Though many “best” companies bounce back, their stock underperformance continues for some time.

THE SECOND EVENT TRIGGER

Investors do not expect positive surprises from companies they consider to have poor outlooks. When such surprises 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.

The second type of event trigger is a positive surprise—or a series of positive surprises—for an out-of-favor stock. Take the example of Reynolds American. The company is the second largest cigarette tobacco producer in the United States and was as out of favor as a stock can be.

Through a number of acquisitions, including Conwood Smokeless Tobacco, Reynolds increased its revenues significantly in an industry in which consumption is dropping each year. Reynolds stated publicly that it could increase its profits substantially by consolidating its operations in North Carolina, thereby eliminating well over a billion dollars of expenses and excess plants. The company did exactly that. Beginning with its March 2004 quarter, it produced a string of large earnings surprises, which pushed the stock up 154 percent, including its high 6 percent dividend (a return we can only dream of today) in mid-2007. Investors who bought this stock—and naturally more than a few wouldn’t—did very well.

An Earnings Surprise for a Stock Is Reinforced
by Additional Earnings Surprises

Investors’ perceptions about a company, an industry, or the market itself often do not change with a single positive or negative surprise. Jeffery Abarbanell and Victor Bernard of the University of Michigan, for example, have studied analysts’ estimates and found they are slow to adjust to earnings surprises. Whether the estimate was too high or too low, analysts do not revise it accurately immediately but take as long as three quarters after the surprise to do so.8 When a forecast is too high, it continues to be high for the next nine months, and when it is too low, it continues to be low for the next three quarters.

As Abarbanell and Bernard put it, analysts “underreact to recent earnings reports.” This underreaction generates new surprises, which reinforce investors’ changing opinion of a company. If, for example, investors are taken aback by a negative earnings surprise on a favorite stock and more negative surprises occur in the following quarters (as a result of analysts’ not revising their earnings estimates down enough), people’s increasingly poor reappraisal of the company pushes the stock even lower. The event trigger continues over a number of quarters, as we have seen in the various annual quarterly and annual surprise charts. The same is true for a series of positive surprises on an out-of-favor company.9

The Effects of Reinforcing Events

The second category of earnings surprises is what I call a “reinforcing event.” Rather than changing investors’ perceptions about a stock, these surprises reinforce the current beliefs about the company. Since they do, they should have much less impact on stock prices. Reinforcing events are defined as positive surprises on favored stocks or negative surprises on out-of-favor stocks. A positive surprise on a favored stock reinforces the previous perception that this is an excellent company. Good companies should do well; if they have positive surprises, it is only to be expected.

Microsoft is the world’s largest developer and manufacturer of software and has a major stake in computer equipment. The company is a classic example of a favorite stock experiencing a reinforcing event. In late 2003, “Mr. Softy,” as it’s sometimes called, racked up good growth in both the consumer and the small and medium-sized business markets. It beat estimates handily in late 2003 and early 2004. However, within only a few months the stock was down about 14 percent, and two years later in mid-2006 it was still down about 13 percent, well behind the market. Again a premier company at a premier P/E showed so-so returns even with very positive earnings surprises.

Boeing was an example of a reinforcing event on an out-of-favor stock several years back. The company hit a rough patch with a machinists’ strike and charges related to its 747 and 787 programs, as well as continued woes caused by the global economic downturn that put pressure on its vital commercial airline markets. After missing estimates on the downside four quarters in a row, starting in June 2008, it dropped into the most out-of-favor group, bottoming at $29 per share in March 2009. But it came back strongly, rising over 165 percent by April 2010. Not a bad return from a company whose earnings continued to disappoint!

Figure 9-7 shows how different the impact of earnings surprises is on event triggers and reinforcing events for the surprise quarter (on the left), as well as for the full year (on the right). The figure uses price-earnings ratios to measure the surprise effect, but using price-to-cash-flow or price-to-book-value ratios results in very similar comparisons. The two types of event triggers (negative surprises on favored stocks and positive surprises on out-of-favor stocks) have substantially more impact on stock prices than reinforcing events (positive surprises on favored and negative surprises on out-of-favor issues).

Look first at the event triggers in Figure 9-7, the first two adjoining columns on the left side of the chart, for both the quarter and the year. We see for the event trigger that, adding them together for the average quarter, the total price impact is 5.7 percent (+2.6 percent and –3.1 percent, removing the signs) in the surprise quarter. By contrast, adding the reinforcing events together (the last two adjoining columns on the right side of the quarterly chart) results in a much smaller surprise impact: 1.3 percent (1.1 percent and –0.2 percent) for the same quarter. For the full year, we also see that the size of the event triggers more than doubles, resulting in a total impact of 14.1 percent. This is because, as we saw, positive surprises for out-of-favor stocks and negative surprises for favored stocks are much larger for the full year than for the surprise quarter alone. Reinforcing events, on the other hand, have a negligible 0.6 percent impact on prices after one year.

Figure 9-7 demonstrates not only two distinct classes of surprises, event triggers and reinforcing events, but the fact that their response to unanticipated good and bad news is remarkably different. Event triggers result in a perceptual change, which continues through the end of the year and has a major impact on stock prices.

The effect of reinforcing events on prices, on the other hand, is minor by the end of the twelve months following the surprise.

Neuroeconomics and the Market

Neuroeconomics is an important new discipline within economics. Major contributors to this rapidly growing field have written about a significant amount of new research work that appears to strongly support the hypothesis that at least a part of the earnings surprise findings, particularly event triggers and reinforcing events, can be attributed to relatively new research in this field: specifically, the four different types of surprise we saw in Figure 9-7.

We do not need to be experts in biology, chemistry, and neuropsychology to understand the powerful answers that this new discipline gives for why all four kinds of surprises play out the way they do. Fortunately, understanding the interactions themselves is much simpler.

Let’s start with dopamine, a chemical naturally released by the body that is commonly associated with the pleasure systems of brain chemistry. It provides feelings of enjoyment and reinforcement, which motivate a person to undertake certain activities. Dopamine, a neural transmitter, transmits nerve impulses, which are released by naturally rewarding experiences such as food, sex, certain drugs, and the neural stimuli associated with them. Of the brain’s approximately 100 billion neurons, only about one-thousandth of 1 percent produce dopamine. But this minuscule group has a major effect on how your brain makes certain choices, including investment decisions. It also plays a major role in both alcohol and drug abuse. As Jason Zweig, a respected columnist and author, wrote in Your Money and Your Brain, alcohol, marijuana, cocaine, morphine, and amphetamines all seem to be related to the release of dopamine. “All hook their users by affecting in a variety of ways the trigger zones for dopamine in the brain.”10 A hit of cocaine, for example, tells the brain to release dopamine about fifteen times as fast as normal, indicating that it may somehow help transmit the euphoric kick of the drug. “Dopamine spreads its fingers all over the brain,” says a neuroscientist, Antoine Bechara of the University of Southern California, of this process.11 When the dopamine neurons are lit up, they send gushers of energy throughout the brain that make and put decisions into actions. Ironically, the brain patterns look almost identical when dopamine is quickly activated after the inhalation of cocaine and when an investor is excited by an investment decision he has just made.12

Dopamine is more than simply a rush on its own. An investor must know more: that there’s a sizable reward in taking a given action. He must also take the required actions that he thinks will capture the reward.

Next, let’s look at the role of dopamine in the various forms of earnings surprises examined. Dopamine neurons are released by rewarding events that are better than predicted, remain uninfluenced by events that are as good as predicted, and are depressed by events that are worse than predicted. This, it appears, is the key reason why effects of the four forms of earnings surprises we just examined have been so consistent over time. Remember: the possibility that the event trigger and the reinforcing events are not random is about 1,000 to 1. If the link between neuroeconomics and earnings surprises stands—and the evidence certainly points that way—this might forge a strong bond between predictable and repetitive economic events and neuroeconomic and Affect findings. These correlations, given the high odds that event triggers and reinforcing events are not pure chance, are highly probable. If this is the case, the similarity of findings in neuroeconomic experiments to those on earnings surprise presents a fascinating topic of research. If the current experiments do show a tie between the two, neuroeconomics as a major economic research tool will certainly become far more important.

Let’s briefly look at neuroeconomics research that appears to explain the four categories of classes of earnings surprises, which, as we know, divide into two distinct categories, event triggers and reinforcing events. The researchers Wolfram Schultz of the University of Cambridge (Department of Physiology, Development and Neuroscience), Read Montague at Baylor College of Medicine, and Peter Dayan at University College London have made a number of important research findings about dopamine and reward. They discovered that getting what you anticipated produces no dopamine rush, sending out electromechanical pulses at their resting rate of about three bursts per second. Even though a reward is expected to make investors enthusiastic, it does not. This is almost precisely what we see with the high-P/E phenomenon with positive surprises and negative surprises on out-of-favor stocks with reinforcing events. The reward—in this case a positive surprise on a favored stock—is actually more than investors expected, but the reaction is almost nebulous and sometimes negative. This may also explain why drug addicts require larger hits to get the same high and why investors require larger earnings hits on “best stocks to see their prices move higher.”

To neuroeconomists, the two event triggers would be the real surprises. They are major unexpected events. According to a research study by Pammi Chandrasekhar, C. Monica Capra, Sara Moore, Charles Noussair, and Gregory Berns,13 higher-than-expected rewards are unanticipated and as a result release dopamine. Looking at event triggers shows that a positive earnings surprise for an unfavored stock is also unanticipated by investors holding or interested in the stock. They are likely to experience “rejoice” or elation when their stock shows a positive earnings surprise, and their brains release dopamine.

Research findings on monkeys also show strong results for unanticipated positive surprises. (I apologize to readers who might be offended by the comparison of monkeys to humans. In my defense I can only point out that monkeys, chimpanzees, and pigeons scored higher on some of these neuropsychology tests than did people.)

Schultz studied the brains of monkeys and found that when dopamine comes as the result of a surprise the dopamine neurons fire more strongly and for a longer time than for a reward that was anticipated beforehand.14 This research, although only now being tested on event triggers, appears to support the unanticipated positive surprise on low-P/E stocks in the event trigger. When investors receive unexpectedly higher earnings on out-of-favor stocks, their dopamine is also likely to fire up almost instantaneously and strongly—Schultz’s studies show from three to forty times a second. In Schultz’s words, “This kind of positive reinforcement creates a special kind of attention dedicated to rewards. Rewards are what keep you coming back for more.”15 Schultz and Anthony Dickinson, in the 2000 Annual Review of Neuroscience, wrote, “In summary, the reward responses depend on the difference between the occurrence and the prediction of reward (dopamine response = reward occurred – reward predicted).”16

Chandrasekhar and colleagues’ results suggest that activation of a neural network consisting of the rostral anterior cingulate, left hippocampus, left ventral striatum, and brainstem/midbrain is correlated with rejoicing.17 Don’t worry, this is not a test; it’s merely here to show how complex these neural interactions can be. Similarly, the second event trigger, a negative surprise on a favorite stock, might cause regret and disappointment. In this case another neural network, the cortical network, is activated. Neuroeconomists can measure the two classes of surprises by using functional magnetic resonance imaging (fMRI). This network activates the degree of regret.18

Schultz, Montague, and Dayan also found that if rewards we expect don’t pan out, dopamine dries up.19 Dopamine neurons activate when people spot a signal that the reward is coming, but if it doesn’t come, they will instantly stop firing. The brain is thus deprived of its expected shot of dopamine, and disappointment sets in. This is similar to the reaction we see in the earnings surprise on a favored stock that has a negative surprise (an event trigger). Schultz and Dickinson also observed that omitted rewards induce opposite changes in dopamine neurons compared with unpredicted rewards. If a predicted reward fails to occur, dopamine neurons are depressed at the time the reward would have occurred. This suggests a form of error coding that is compatible with the idea that the error directly controls learning about the prediction.20 The fact that there is no positive reward, but a negative consequence, for each security in the best-stock negative-surprise portfolio quite possibly is responsible for the significant, immediate, and then continuing drop in price. As we have seen, both the positive and the negative effects last for at least four quarters.

Reinforcing events, the two other classes of earnings surprises we noted—a positive surprise on a favored company and a negative surprise on an out-of-favor stock—do not seem to have much impact on our neuroprocessing or, for that matter, in the marketplace, from what the neuropsychologists report in related studies. For example, winning a bet when it is highly probable evokes less rejoicing than winning a bet when the outlook was unlikely. Similarly, losing a bet when the outcome is probable evokes less regret than losing a bet when the outlook is improbable. Chandrasekhar and colleagues indicate that the degree of regret or rejoicing correlates with the perceived probabilities of winning or losing. The higher the expectation of winning, the lower the amount of rejoicing; and the lower the expectation of winning, the higher the amount of rejoicing. Also noted was that different brain regions exhibited activation that increased with the levels both of regret and rejoicing. The authors conclude, “Our results suggest that distinct but overlapping networks are involved in the experiences of regret and joy.”21 What seems apparent from this analysis is that expected positive earnings surprises for favorite stocks result in only a small amount of rejoicing. The same is likely of regret for negative surprises on out-of-favor stocks.

Figure 9-8 demonstrates that this is exactly what happens with the stocks we have labeled as reinforcing events.*54 Also of interest is the difference in the size of event triggers and reinforcing events, as the neuroeconomists’ work would suggest. The event trigger’s impact on stock prices is about four times as much as that of reinforcing events in the quarter of the surprise, and almost twenty-four times as much after one year (removing signs on both). The chart is statistically significant at the 0.1 percent level; this means that there is only a 1-in-1,000 possibility that it could be sheer chance. For the investor it clearly provides some robust neuroeconomics findings that appear to strongly support the purchase of out-of-favor stocks.

The Effects of Surprise over Time

We have seen the results of surprises on “best” and “worst” stocks for up to one year after the surprise is announced. Are there lingering effects beyond that? Figure 9-9, which measures the performance of the “best” and “worst” groups of stocks by P/E ratios for five-year periods following an earnings surprise, using a buy-and-hold strategy, provides the answer.*55 The figure indicates that the lowest-P/E group showing positive earnings surprises (low-P/E positive) outperformed the market in all twenty quarters after the surprises and recorded an above-market return of 30.3 percent for the five-year period. Conversely, the highest-P/E group receiving negative surprises (high-P/E negative) underperformed in every quarter for the following five years, lagging behind the market by 30.4 percent for the full period. As we can see, the differential between the two groups continued to increase significantly through the five years measured.

Is the entire difference in performance between the two types of event triggers caused by earnings surprises? Did the original surprises change investors’ perceptions permanently? These questions are impossible to answer statistically at this time. We do know that investors were far too confident of their prognostications for both “best” and “worst” stocks; consequently, “best” stocks were significantly overvalued and “worst” stocks were undervalued. When the dark or rose-colored glasses were removed, perhaps they were swapped for each other. As was also noted earlier, not one but a series of surprises may occur, some in later quarters, including surprises other than analysts’ forecast errors, that continue to reinforce the price reevaluations.

What we can say, however, is that the enormous market outperformance by the low-P/E and other low-value groups*56 and the underperformance by the highest quintile in each value group indicate that there certainly had to be an event or a series of events that changed investors’ perceptions of what were “best” and “worst” stocks.

We also see the effects of reinforcing events. “Worst” stocks with negative surprises (low-P/E negative) consistently outperformed after the surprise quarter and for the next nineteen quarters, while “best” stocks with positive surprises (high-P/E positive) just as consistently underperformed. Although the differences are not as large as for “best” and “worst” stocks that experienced an event trigger in the surprise quarter, they are still major. “Best” stocks underperformed the market by 21.3 percent in the full five-year periods, while “worst” stocks outperformed by 20.4 percent. (The results for the two other value measures, price to cash flow and price to book value, are again similar.)

The middle group is not shown. However, the long-term findings differ little from those at the end of the first year. Surprise has a major effect only in the quarter in which the news is announced. After that the stocks perform in line with the market. Overall, positive and negative surprises almost cancel each other out, and this is pretty much what we should expect, since being in the middle group shows that the stocks are not overvalued or undervalued by much.

A Surprising Opportunity

Psychological Guideline 18 positioned us in out-of-favor stocks to take advantage of analysts’ forecast errors and other surprises. We can now go further in delineating the effect of surprises, which will prove an essential tool for the strategies to be outlined shortly. Psychological Guideline 20 summarizes our findings on surprise.

 

PSYCHOLOGICAL GUIDELINE 20(a): Surprises, as a group, improve the performance of out-of-favor stocks, while impairing the performance of favorites.

PSYCHOLOGICAL GUIDELINE 20(b): Positive surprises result in major appreciation for out-of-favor stocks, while having minimal impact on favorites.

PSYCHOLOGICAL GUIDELINE 20(c): Negative surprises result in major drops in the price of favorites, while having virtually no impact on out-of-favor stocks.

PSYCHOLOGICAL GUIDELINE 20(d): The effect of an earnings surprise continues for an extended period of time.

In this chapter, we have examined the role of surprises and have found that they consistently favor stocks that investors believe have poor outlooks and just as consistently work against those believed to be la crème. Because of the frequency of earnings surprises demonstrated in the preceding chapter, we know they are a powerful force acting to reverse previous over- or undervaluations of stocks.

Just how important surprises and the resulting changes in investors expectations are in developing powerful investment strategies will be shown in the next chapter. With our probabilities of winning moving increasingly higher, it’s almost time to roll up our sleeves and sit down at a table in the investment casino. Now, what sort of odds would you care to have?