It’s been a bad year for professional forecasters, especially those who failed to call the results of both the EU referendum and US election. As for those who predicted that a vote for Brexit and a victory for Trump would cause a stock market collapse… so far they’ve been wrong, too. It’s a reminder just how cautious you have to be when it comes to relying on any kind of forecast. For investors in particular, the predictions of analysts need careful handling.
It’s undeniable that earnings forecasts are woven into the fabric of the stock market. But there are some who wonder why anyone bothers to listen to them. The late American economist Edgar Fiedler wrote in The Three Rs of Economic Forecasting: “The herd instinct among forecasters makes sheep look like independent thinkers.” Meanwhile, David Dreman, the famously contrarian value investor, wrote that: “analysts’ forecasts are usually overly optimistic.”
Despite the bad press that some analysts get (and to be fair, some are highly regarded), there are ways of putting their insights to good use. In October I looked at how earnings forecast ‘upgrades’ can be a clue to finding firms on the move. Another way to slice and dice what analysts have to say, is to look for companies that are actually beating expectations. Indeed, we’ve seen some big moves in some of these stocks in recent months. So what are the signs of an earning ‘surprise’ - and what should you look for?
How surprises trigger price momentum
Traditionally, an earnings surprise has been the kind of event where everyone wins. Company management are high-fived, analysts keep their jobs and investors enjoy a rising share price. It’s a picture supported by academic evidence. Over the past 20 years, research has found that earnings surprises trigger positive price momentum. The idea is that as investors get to grips with the full meaning of an earnings ‘beat’, they gradually drive up the price.
One of the classics in this field is a paper by Josef Lakonishok among others. It draws a direct link between earnings surprises and upward price drift. They found it works particularly well in smaller, more cheaply priced ‘value’ stocks. Lakonishok went on to set up his own mutual fund using these precisely these findings. Some years later, Narasimhan Jegadeesh and Joshua Livnat took it further. Their research found that a more…
