How to read between the lines of analyst research

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 an earnings upgrade from an analyst - you should expect to see upward price momentum. If the news was bad, you should expect to see the opposite.”

Earnings momentum strategies are outperforming

Over the past year, investing strategies that actively seek out earnings forecast upgrades and earning surprises have been performing well. This is probably what we’d expect in a period of reasonable economic growth and strong market conditions.

With the Earnings Upgrade Momentum screen, the idea is to find companies that are seeing their forecasts upped by the highest rate. It could be a sign that something in the company has changed - and the first signal of that change is a ratcheting up of earnings forecasts.

Over the past year, we’ve seen a 40.5% return from this strategy, which specifically looks for at least a 5% increase in consensus earning forecasts for the next financial year during the past month. Here’s a snapshot of the current list:

 Meanwhile, the Earnings Surprise screen has returned 35.3% over the past year. As the name suggests, this looks for companies that have beaten sales and earnings forecasts by a wide margin in their most recent results. Again, here are a few of the passing candidates now: 

Like the Earnings Upgrades screen, the Earnings Surprise strategy is grounded in findings from academic research into the momentum effects caused by unexpected earnings events. It’s worth saying that while these strategies often pick up high momentum firms, it’s also true that there can be some false positives. That’s because it’s possible for so-so businesses to pass the rules if they’ve performed not quite as badly as they were expected to or they’re having their forecasts increased from a low base. 

Earnings momentum strategies on the move

While analyst research and earnings forecasts divide opinion, there’s no doubt they offer useful ways of finding stocks on the move. For that reason, ‘earnings momentum’ signals represent half the weighting of Stockopedia’s overall Momentum Rank. 

Earning forecast upgrades and earnings surprises hinge on the views of analysts and how companies perform against them. These stocks have been shown to benefit from price momentum caused by the market being slow to react to changes in their earnings outlook. Momentum strategies do need careful watching, but in the upbeat conditions we’ve seen over the past year these approaches have worked very well.