Revisions Ratios Uncover Hidden Gems

Our Director of Zacks Equity Research Dirk van Dijk, CFA slices and dices all sorts of data on publicly traded industries. Recently, we got his take on something called a “revisions ratio,” and managed to get a few Buy recommendations in the process.

You track something called a “revisions ratio.” Could you tell us a little about it?

To help gauge the direction of the market, we take note of what analysts are thinking. By tallying their EPS changes, we can determine our “revisions ratio.” This ratio simply divides the total number of positive estimate revisions by the total number of estimate cuts. Thus, a high ratio is a bullish indicator and a low ratio is bearish. For the S&P 500 as a whole, a number below 0.80 or above 1.25 is generally significant. For individual sectors the distance from 1.0 should be greater for the numbers to be significant.

And how have performances been in the quarter just reported?

With positive surprises outnumbering disappointments by almost five to two, it is not a shock that the revisions ratio has started to climb from the depths. After all, second-quarter earnings are part of full-year 2008 earnings, so if a company posts a positive surprise and the analysts don’t raise full-year earnings, they are implicitly cutting estimates for the third or fourth quarters.

It is now at 1.08, a reading that is neutral, up from 1.05 last week, and 0.98 two weeks ago. The overall pace of estimate revisions continues its rise, and is approaching its seasonal peak. Over the last four weeks there have been 3,727 changes in estimates: 1,939 up and 1,788 down, up 3.5% from 3,600: 1,841 up and 1,759 down last week. This week or next should mark the peak of total revisions activity for the quarter. The ratio of firms with rising mean estimates to falling mean estimates is 1.02, slightly weaker than the revisions ratio, but also in neutral territory.

According to the revisions ratio, which industries performed best?

On the back of their strong surprise ratios, Health Care and Industrials have moved into the top slots for the 2008 revisions ratio, with readings of 2.94 and 2.57, respectively. Surprises have not been as strong for Energy (2.4:1 ratio, 2.65% median surprise), but it still has a respectable reading of 1.26. Still, this is way down from where it was a month or two ago, as lower oil prices work their way into analysts forecasts for this year.

Financials and Discretionary are the weak sisters with readings of 0.53 and 0.74, respectively. However, these readings represent a significant improvement over what we were seeing before earnings season.

Which specific companies look to benefit from this?

Notable Health Care stocks on the upside include Johnson & Johnson (JNJ), St. Jude (STJ) and Wyeth (WYE). The Aerospace and Defense names were particularly strong among the Industrials, including General Dynamics (GD), Lockheed Martin (LMT) and Honeywell (HON).

And where should investors stay wary?

In the Consumer Discretionary sector, the analysts slammed the brakes on the Auto companies Ford (F) and General Motors (GM). In the Financials, many of the regional banks continue to get hit, with noteworthy declines in National City (NCC), Regions Financial (RF), Washington Mutual (WM) and Zion (ZION).

Dirk van Dijk, CFA is the Director of Zacks Equity Research.

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