While the opinions of brokers often attract legitimate scepticism among investors, there’s little doubt that anyone keeping an eye on our analyst upgrade screen recently would have been impressed. Of all the investing strategies we track here at Stockopedia, the Earnings Upgrade Momentum screen has wiped the floor with most of the others and, unlike some of the other best-performing screens, it comes with decent levels of diversification to boot. Over six months it has returned a startling 55.6% against a healthy gain of 17.8% in the FTSE 100, which ties in with the performance of a similar AAII screen which has trounced the index for over a decade. So what’s causing these impressive screen returns?
Who cares what brokers say?
A glance over the decades of research into the impact that broker research can have on stock prices reveals that investors need to tread carefully, particularly if you are thinking of trading on ‘buy’ and ‘sell’ recommendations. Despite the way you see broker recommendations bandied around by bulls on bulletin boards, the research shows that the price impact of new ‘buys’ and ‘sells’ is sudden and short-lived – and because of the bias inherent in much broker research, sometimes analyst buy recommendations are best used as a contrarian indicator!
However, a strategy based on trading on changes in broker estimates, rather than recommendations, is supported by much more promising research. This is likely to do with freshness. Barber et al found that nearly 50% of all recommendations are left unchanged when they are revisited, approximately 300 days after they were first made. Earnings forecasts, in contrast, are generally more responsive to short-term news events (being revised on a quarterly or even monthly basis).
Among the most compelling research that found in favour of earning upgrades was a 1996 study by Phillip McKnight and Steven Todd. They assessed the revision anomaly across Europe and found that stocks with the greatest number of upward revisions in earnings, net of downward revisions, achieved significantly higher returns than otherwise similar stocks. They tracked a portfolio of shares in the highest 20% of net upward revisions and found that it outperformed the bottom 20% of upward revisions by more than 16% annually.
McKnight and Todd concluded that an EPS revisions strategy worked so effectively because ‘bad news travels quickly, but good news travels slowly’. In other words, investors are quick to respond to downgrades, which means the market is acting efficiently at pricing-in bad news. But with positive revisions, investors are more likely to take a wait-and-see approach. They blamed this on investors being all too aware that analysts can be susceptible to bias and being over-optimistic. As a result, the impact of earnings upgrades on share prices – and the underlying information that is driving those upgrades - takes time to be fully priced in.
Stocks on the move
As you can see from the Rules below, our Earnings Upgrade Momentum screen mainly focuses in on stocks that have seen over the past month the greatest percentage earnings-per-share upgrades for the year after next (remember you can fork any of our screens to add your own interpretation).
Among the top qualifying stocks currently on the screen is Carphone Warehouse (LON:CPW), the mobile phone retailer. It recently moved to take control of its retail operations across Europe by buying-out US joint venture partner Best Buy in a deal it said would be earnings enhancing. Combined with a robust fourth quarter trading update, the company’s shares were propelled by more than 50p to over 240p.
On each of our stock reports, we show the recent change in consensus for the next year – as you can see from this chart, brokers have dramatically upgraded their 2013 EPS forecasts of late, up by 34.8% over the past month. It will be interesting to see whether this has now been priced in or whether Carphone Warehouse shares can keep up their price momentum in the coming months.
Shares in betting group Betfair (LON:BET) leapt in April on news that it had become a $1.5 billion target of private equity company CVC. While buy-out talks were terminated last week, Betfair’s new management team have been keen to stress that their efforts to turnaround the company’s fortunes are beginning to bear fruit. It recently said it was on course to beat full year earnings guidance and that it was enjoying ‘strong strategic momentum’. Brokers have upgraded their two-year EPS forecasts by 29.1% over the past month, signalling optimism that investors might be on to a winner.
Commercial vehicle hire company Northgate (LON:NTG) has seen its share price double to 334p since last June but hire rates in its UK and Spanish markets have dipped recently, causing a near-term reduction in forecasts. However, Northgate seems to be a bet on improving economic conditions in those markets, with two-year consensus forecasts upgraded by 17.7% over the past month. We’ll hear more from Northgate when it reports its full year results at the end of June, but recent statements indicate that it is confident of growing its business in the UK and squeezing better returns from investments in expansion.
Brokers have been gradually downgrading their EPS forecasts for hedge fund manager Man (LON:EMG) over the past 12 months but there are signs that sentiment might be changing. Since taking the reigns as CEO in February, Emmanuel Roman has been trying to stem redemptions from the group’s funds, albeit unsuccessfully. However, over the past month there has been an 11% upgrade in consensus EPS forecasts for the next two years, helped by news that Man intends to redeem much of its debt and may begin buying back its own shares. That has breathed life into the share price, which has risen from 105p to 129p over the past four weeks.
One final company that may be worth mentioning from the Earnings Upgrade Momentum screen right now is ARM Holdings (LON:ARM), which makes chips for iPhones among other things. ARM has been a remarkable story stock over the past three years, in which time it has added £10 to its share price (currently around 1093p). While recent headlines have begun to raise doubts about its ability to continue growing, it’s notable that 20 of its brokers upgraded their two-year earnings forecasts for the stock during the past month, representing a consensus increase of 5.26%. Over the same period, the share price increased in value by 221p, currently leaving it within a whisker of its 52 week high. Still, by many valuation metrics, it now looks super expensive so, again, it will be fascinating to see whether the stock can maintain its momentum.
Weight of momentum
Last week, I wrote about how companies surprising versus consensus expectations were enjoying some strong share price performances. Joining the dots between these kinds of earnings ‘surprises’ and positive price momentum is grounded in a whole host of research. It turns out that surprises sometimes cause a price lag that can take months for the market to correct and as momentum takes hold, investors can ride the wave. In many ways, earnings surprises and earnings upgrades are in the same investing league. Both events have been linked to several months of positive price momentum (or negative momentum in the case of downgrades and earnings disappointments) as the market slowly digests their implications.
Given the performance of the Earnings Upgrade Momentum screen over the past year, it seems that taking note of broker upgrades and the price momentum they can cause, could be a profitable strategy. As always, there is a need for caution, not least because any strategy based on following analysts brings with it questions about the credibility of the underlying analysis. Just like ‘buy’ and ‘sell’ recommendations, earnings revisions are susceptible to bias and the behavioural instincts that cause analysts to herd together. Still, the evidence of this screen so far suggest that there may be an interesting mispricing effect here for investors.
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