With corporate earnings season just around the corner, Todd Gervasini, a portfolio manager at Wakefield Asset Management, is giving a lot of thought to potential stock-market winners and losers.
Information technology and energy stocks should beat estimates and outperform, he says — especially Meta Platforms
META,
Applied Materials
AMAT,
Cadence Design Systems
CDNS,
Fortinet
FTNT,
and Marathon Petroleum
MPC,
But be careful with consumer staples, industrials and communications services stocks like telecom and cable company names, he adds.
Why should you listen to Gervasini? For starters, the firm he founded has a great investment track record. Since inception in April 1997 through June 2023, the Wakefield Large-Cap Equity Portfolio gained 11.6% annualized vs. 8.8% for the S&P 500
SPX.
Gervasini also is an expert in earnings and earnings-surprise trends.
Here’s a look at five lessons we can learn about investing from how Gervasini gets his edge, and stocks that look attractive to him now.
1. Exploit the psychology of sell-side analyst crowd behavior to find big, unexpected earnings growth: Job security is fundamental. On Wall Street, this translates into a basic rule of thumb for sell-side analysts: It’s better to be wrong with the pack than on your own as an outlier. After all, if you’re wrong with the group, you can always say “Well, everyone else got it wrong, so don’t fire me!”
This dynamic leads to a way to predict “unexpected” earnings growth not priced into a stock. For instance, if an analyst expects a company’s earnings will grow to $2 per share next year from $1, but the average forecast is $1.50, he’s more likely to publicly increase his estimate to $1.50 or $1.60. This conservative stance tells you more upward estimates are on the way. Then, as the company’s growth story is confirmed, the analyst will move earnings estimates higher. In short, you want to own companies getting decent upward estimate revisions, because it’s likely that more are coming.
Developed in the early 1990s, this stock-selection system is called “earnings estimate revisions analysis.” In the vernacular, Wall Streeters call it the “cockroach theory” because when you have seen one upward estimate revision, there are probably more where that came from.
Revisions analysis is at the core of Gervasini’s investing approach. “We are trying to take advantage of sell-side behavior,” he says. “It is predictable behavior and you can get into stocks before future revisions happen.”
A good example, Gervasini says, is Meta Platforms, a stock he purchased in February 2023. Even though the shares are up 138% so far this year, Gervasini still likes Meta because it continues to rank well in his estimate revisions model. A more recent purchase that ranks well is Marathon Petroleum, which he bought in August.
2. Find companies that will continue to surprise on earnings: Gervasini’s model here tells him when earnings surprises are on the way. Key factors include the size of a recent surprise in the absolute sense, and relative to the average for both the company’s sector and the market overall. The model also favors surprises that are reversals from prior disappointments. Companies with good estimate revisions may also likely surprise.
A prime example here is insurer Arch Capital Group
ACGL,
Gervasini and his team bought this stock in May because it had posted a series of earnings surprises, including a big 59% surprise last February. He still owns the stock because it has continued to surprise and rank well in his estimate revisions and surprise models. This suggests it may surprise again when it reports on October 24.
Caterpillar
CAT,
is another example. The company missed slightly on fourth-quarter 2022 earnings and then surprised nicely in the following two quarters.
3. Take the emotion out of investing: The sell decision always seems to be much harder than the buy decision. Why is this? It’s all about emotion. “If you have a company that has done unbelievably well, it is hard to sell. You fall in love with the company,” Gervasini says. The same thing can happen in the opposite direction: Too many people hold on to losers because it is hard to admit they made a mistake.
Gervasini avoids these pitfalls in two ways: If a holding no longer ranks well in his estimate revisions, surprise and valuation models, he sells. He uses position size as a guide. He likes positions to be around 3.3% of the portfolio. When they grow to 4%, he trims. If positions fall to 2.1%, he adds.
“This forces us to sell what has done well and buy what is highly ranked but has not done well. It takes the emotion off the table,” he says. One stock that looks buyable because it has fallen to around 2.1% of the portfolio (but still ranks well) is Hershey
HSY,
4. Buy what is out of favor: To understand Gervasini’s tactics here, you need to recall the difference between the market-cap and equal-weighted S&P 500. The equal-weight S&P 500 index owns all stocks in the index in equal size. In the market cap weighted index, bigger market-cap names have a proportionately larger representation.
This difference offers a way to stay out of extremely popular names that are probably overvalued because the crowd loves them, and favor names that investors do not like. The trick is to keep your portfolio sector neutral relative to the equal-weighted version of an index. This gives you a relatively a small position in popular sectors overrepresented in the cap-weighted index, and bigger positions in out of favor groups.
Let’s take an example. Because the “Magnificent Seven” tech names including Microsoft
MSFT,
Alphabet
GOOGL,
Nvidia
NVDA,
and Meta have performed so well, computer and technology stocks recently accounted for 35% of the market-cap weighted S&P 500. If instead you owned the 15% they represent in the equal-weighted S&P 500, you have relatively low exposure to this group compared to the S&P 500 market-cap weighted index. Meta Platforms is the only stock Gervasini has in this group, because it still ranks well for earnings revisions and surprises and is still arguably cheap.
The same tactic gives you an overweight position in unliked groups, such as financials. Match the equal-weighted index by having 17% of your portfolio in financials, and you are overweight the group relative to their 10% representation in the cap-weighted S&P 500.
“This keeps us out of insane multiples and makes us buy boring stocks that I think will ultimately be rewarded,” Gervasini says. “It forces us to look at the sectors that people ignore.” In financials, this means owning Arch Capital Group, JPMorgan Chase
JPM,
and insurance giant AFLAC
AFL,
5. Mind the valuations: Another way to invest in out-of-favor names is to own stocks that look cheap relative to their groups. Caterpillar, for instance, trades at a p/e of 15.47 compared to its sector p/e of 48.8, Gervasini says. Meta Platforms trades at a p/e 19.6 vs. 45.8 for its group. Marathon Petroleum has a p/e of 6.0 vs. 18.4, and Arch Capital group trades at a p/e of 13.0 compared to 14.7 for its peers.
Gervasini also likes to keep things simple by using only the three tests described above: earnings estimate revisions; earnings surprise, and relative valuation. He says: “We are all-in on the concepts that we think are very robust. That’s where the opportunity to outperform is.”
More: Why stocks are likely to be especially volatile this October
Plus: ‘Anxiety’ high as stock market falls, bond yields rise — what investors need to know after S&P 500’s worst month of 2023
