Beating earnings expectations tends to be a sure fire way for companies to hit the financial headlines and get a warm reception from shareholders on results day. For momentum investors with an eye for a surprise, keeping track of these City stars has long been acknowledged as a profitable strategy. Not only that, but a review of London listed stocks that have sprung positive surprises over the past year shows that a number of them also come with potentially attractive valuations. 

Why earnings surprises matter 

The investment case for earnings surprises isn’t new; academics have been studying the effectiveness of earnings surprise-based trading strategies for decades while some hedge funds swear by them. Back in 1968, two US finance professors called Ball and Brown started the debate with research showing that in any given year, companies with the largest increases in earnings also had the largest increases in share price. Although the findings were obviously expected, one unusual factor that emerged was that those same stocks saw their share prices carry on rising over a period of up to three months after reporting their earnings. 

This sort of pricing lag is a sensitive subject for those who believe the stock market is efficient. Ordinarily you might expect the market to seamlessly incorporate the full implications of an earning surprise into a stock price, but in study after study this is shown not to be the case. Naturally, academics have turned their attention to finding out what causes this so-called ‘post earnings announcement drift’, or earnings momentum, and why the market can be so inefficient at pricing-in earnings news. 

What many have since concluded is that it’s the ‘surprise’ component of an earnings announcement that causes the delay. In particular, analysts and investors are slow to react to the full implications of the news – a factor that’s widely believed to be a major driver of price momentum generally. A 2005 study by Jegadeesh and Livnat found that analysts can take as long as six months to incorporate earnings and revenue surprises into their forecasts. 

There have been numerous attempts to quantify how much of an opportunity earnings surprises represent to investors. In Leonard Zacks’ Handbook of Equity Market Anomalies US professor Daniel Taylor reviews various research and finds that the returns to a long-short strategy based on buying shares…

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