By Michael Brush, MarketWatch
Back in the early 1990s, a small group of investors printed money with a system based on the logic that Wall Street analysts are a lot like cockroaches.
These quants had discovered that just like one of the disgusting little critters, a single upward estimate revision from a Wall Street sell-side analyst typically meant many more were in the wings.
This system cleverly played on the caution of sell-side analysts. When these analysts expected earnings to go up $1 per share in a year, for example, they might roll that out 25 cents at a time. Each time, they’d wait for evidence to confirm the company was still on track to actually book the entire dollar before announcing their next bump upward.
This system — called earnings estimate revisions analysis — worked well enough to create its own demise. Early movers used it to handily beat the S&P 500 and Nasdaq, but by the late 1990s others noticed and arbitraged the edge away.
However, this old system for beating the indexes still works for small-cap international stocks, maintains Daniel Burr, who helps manage the Driehaus International Small Cap Growth Fund /zigman2/quotes/208827456/realtime DRIOX -0.19% . This makes sense because these stocks get less coverage. So there’s a greater chance you can find insights not yet priced into stocks there by reading the earnings estimate tea leaves, for example.
You also see it in Burr’s performance. His fund beats its Morningstar benchmark by 1.4 percentage points per year annualized over the past five years, according to Morningstar. The fund has an expense ratio of 1.23%.
It’s important to note that Burr doesn’t rely on this quant system alone. He and his team do their own research on events like product launches, or the start of a turnaround, to figure out when other investors have missed their significance.
“Investors systematically and chronically underreact to new information,” he says. There’s a simple reason for this. “Some institutions are not set up to understand new information quickly. They are bureaucratic.” Analysis must be run by an investment committee. “We pride ourselves on being nimble, and having a better understanding of news before other people do.”
This is easier to do with foreign small-cap stocks because they aren’t always well covered by the sell side. Recent regulatory changes in Europe forcing brokerage houses to charge explicitly for research make this even worse — or better for Burr. The new rules are reducing sell-side coverage, since brokerages can no longer hide the research expense in other fees.
Big discounts for foreign stocks
Now may be a good time to invest in Burr’s fund because he says small-cap foreign stocks trade at a big discount to their equivalents in the U.S. In Europe, that gap is as big as it has been in 50 years, he says, and emerging-market small cap names also look relatively cheap.
Burr singled out five names from his portfolio, four of which can be easily bought in U.S.-based brokerage accounts since they trade on U.S. exchanges.
The third-largest athletic shoe maker behind Nike /zigman2/quotes/203439053/composite NKE +0.72% and Adidas /zigman2/quotes/203671926/delayed ADDYY +0.17% /zigman2/quotes/206448829/delayed XE:ADS -0.20% , this German company /zigman2/quotes/210450025/delayed PUMSY -0.0013% /zigman2/quotes/203655455/delayed XE:PUM -0.30% has been staging a comeback ever since Bjørn Gulden became CEO in 2013. “It has really taken hold over the past two years,” says Burr. Thanks in part to the use of celebrity influencers on social media like Rihanna and Selena Gomez, Puma is cool again. “This helps them take market share and get shelf space in high quality retailers like Foot Locker /zigman2/quotes/204092533/composite FL +0.20% ,” says Burr.