Earnings forecasts (and the analysts who make them) tend to come in for a bit of stick from seasoned investors. But while their accuracy is sometimes criticised, those forecasts underpin two of the most important measures of so-called ‘earnings momentum’ in companies - forecast upgrades and earnings surprises. Strategies that focus on these events have been doing very well over the past year.

Analysts are supposed to have a deep understanding of the quoted companies they cover. Detailed research and regular access to management means they can work up valuation models and make predictions about future sales and profitability.

But these forecasts are notoriously difficult to make. Equity strategist James Montier once observed: “…analysts are terribly good at telling us what has just happened but of little use in telling us what is going to happen in the future.”

Despite the criticism, many think analyst forecasts are important because the consensus - or average - opinion of analysts is one of the only ways of predicting company performance. In other words, it’s the best (or perhaps least-worst) way for individual investors to gauge how a stock is likely to perform.

Earnings forecasts play with the minds of investors

Academic assessments over the past 30 years or so have highlighted earnings forecast upgrades and earnings surprises as two of the most important events connected to analyst research. That’s because both of them have been shown to cause behavioural turmoil among investors that leads to prices drifting for up to a year.

The idea is that companies receiving sharp increases in earnings forecasts, or beating their earnings forecasts by a surprising margin, force the market to reassess them. In both cases, investors have to absorb the news that the stock is performing, or expected to perform, better than they previously thought. If the price is reaching new highs, it can take time for the market to bid it even higher - even if it deserves it - and that ultimately triggers price momentum.

In the words of finance professor Aswath Damodaran, this is an example of the theory that markets ‘learn slowly’. In his book, Investment Philosophies, Damodaran says events like earnings announcements offer the best support for this idea. He says that one potential explanation is that it take markets a while to assimilate the information.

He explains: “If the initial news was good - a good earnings report or…

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