How Effective is Using Dispersion of Analyst EPS Estimates to Assess Stocks?

Two years ago our post applied the "wisdom of the crowds" principle, made famous by James Surowiecki, to analyst future Earnings Per Share (EPS) estimates to try to differentiate attractive safe Canadian stocks from the not-so-attractive companies. The academic research we uncovered at the time suggested it should be effective but it's always important to check actual results against the theory, so now let's do an update and see what has happened.

As before, we took our 2012 list of the best - the stocks with the lowest dispersion between high and low analyst next year (2013 in the 2012 post) EPS estimates - and the worst - those with the widest spread - and plugged the numbers into a GlobeInvestor WatchList to get the trailing one- and five-year total returns (the sum of capital appreciation plus dividends). Our benchmark for success is the mainstream large company ETF the iShares S&P / TSX 60 Index Fund (TSX symbol: XIU) whose holdings along with the BMO Low Volatility Canadian Equity ETF (TSX: ZLB) and the PowerShares FTSE RAFI Canadian Fundamental Index ETF (TSX: PXC) we had used to assemble 110 candidate stocks.

Low EPS dispersion stocks performed impressively well
In our comparison table below of the lowest dispersion stocks in 2012, green is good, indicating substantially better performance than the benchmark XIU. The one- and five-year total returns of the stocks with the lowest dispersion of EPS estimates in 2012 is very consistently green.

(click on image to enlarge)

In the five-year column, not a single stock under-performed XIU or had negative returns. Only three did only as well as XIU, everything else was miles ahead.

In the one-year column, only two stocks, IGM Financial (TSX: IGM) and North West Company (TSX: NWC), had a negative (red) return. Eight stocks (highlighted in orange) had positive returns, though less than XIU's +15.2%.

High EPS dispersion stocks performed remarkably poorly
Our second table below showing the 2012 highest EPS dispersion stocks is filled with ugly red. There is very little good green or minimally acceptable orange. Only one stock - Franco Nevada Corp (TSX: FNV) - had benchmark beating returns over both one- and five-year periods.

(click to enlarge)

... and the middle EPS dispersion stocks are in between
The returns for the middle group are generally positive, more like the top group than the bottom, but display a larger amount of red and orange in the table below.

(click to enlarge)

BMO's Low Volatility Canadian Equity ETF (TSX: ZLB) in 2012 held a lot more of the low EPS dispersion stocks than either XIU or PXC as the left-most column shows. It is thus little surprise that its 26.9% one-year total return (neither ZLB nor PXC has been around five years so five-year return is not yet available) handily beat that of both its rivals.

Why picking low EPS dispersion stocks might not work as well in the future? The low EPS spread stocks are mostly in the financials, real estate and consumer sectors. Those sectors have done well. On the other hand, the high EPS spread stocks tend to be in energy and materials, both of which sectors have taken a beating in recent years. If those sectors rebound (the price of oil, gold and other commodities being such crucial uncertain variables), their returns could easily leap well ahead of the safe and steady stocks. That wouldn't necessarily mean the safe stocks would have negative returns; more likely they would under-perform.

Bottom Line: The method is not foolproof but looks darn good. Taking note of the dispersion of analyst EPS estimates appears to be an extremely useful factor to consider in stock selection. Low dispersion = good, high dispersion = risky.

This being the case, next week we'll review the current list of attractive and un-attractive stocks. We'll also compare the ETFs and their holdings.

Disclosure: This blogger owns shares of stock symbols REF.UN, BEI.UN, CUF.UN, REI.UN, RY, CNR, NA, NWC, CU, FTS, EMA, MRU, BNS, BMO, BCE, SJR.B, ACO.X, TD, HR.UN, TRP, IFC, EMP.A, POT, IMO, SU, FCR, TCK.B as well as the ZLB and PXC ETFs that own virtually all the stocks in the tables.

Disclaimer: This post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.