How to use earnings surprises to find momentum winners

Companies that beat expectations by a wide margin on results day often see their their share prices leap. But the sudden uplift happens quickly and can leave investors rueing a missed chance of buying shares that might now be hitting new highs. But that isn’t the end of the story when it comes to earnings surprises. Dig into the research and there’s an argument that some of these companies can have a lot further to go.

The emergence of the internet as a source of split-second news and one-click trading has made it much harder to turn an instant profit from stocks releasing positive earnings news. But while these advances have put paid to this once popular strategy, some analysts reckon it’s opened the door to another way to profit… this time using momentum. And a quick glance at the recent strong performance of our Earnings Surprise screen suggests it might be a strategy worth watching in 2016.

Why surprises cause confusion

According to research, companies that surprise the market by beating consensus forecasts often see their prices drift higher over the following three to six months. Among the reasons for this ‘post earnings announcement drift’ is that investors and analysts take time to re-adjust their assessments and expectations of a company. Put simply, the surprise forces them to revisit their assumptions - and that takes time.  

Not only that, but stocks that are catapulted by earnings ‘beats’ cause some peculiar behaviour among investors. On one hand, the argument goes, outsiders are reluctant to buy shares that have already risen strongly in price. While those that already own those ‘winning’ shares tend to sell them too quickly (preferring instead to hold losing positions too long - something known as the ‘disposition effect’).

In combination, these factors momentarily stifle the market’s ability to price the shares correctly. But as the weeks pass, and investors get to grips with the full meaning of the earnings surprise, they buy into the shares and the price gathers momentum.

Why earnings and sales are important

For investors looking to cash in on potential momentum caused by positive surprises, there is an important extra consideration. Academic research has shown that it’s well worth looking for companies that outperform on both earnings and sales. This is crucial because potentially troubled companies can bolster earnings by cutting costs, temporarily masking what could be bad news in the future. By contrast, growing profits in tandem with sales is a much stronger signal.

The key research on this subject is a 2004 paper by Narasimhan Jegadeesh and Joshua Livnat. They found the top 20% of shares in terms of upside earnings surprises outperformed the broader market by 3% over six months and the top 20% in terms of sales surprises outperformed by 2.6%. But a cross sample of the two together managed to outperform the market by a much improved 5.3%. They concluded: “...investors who implement trading strategies based on earnings surprises would benefit by using revenue surprises as an additional signal.”

Those findings are broadly supported by more recent analysis by Professor Robert Novy-Marx. His research has examined the relationship between fundamental (earnings) momentum and price momentum (the tendency for strong price trends to persist). What Novy-Marx argues is that it’s actually the earnings momentum of those stocks - identified by earnings surprises - that drives a lot of the subsequent price gains.

Earnings surprises now

Momentum strategies generally did very well during the very bullish market phase in 2013. They’ve held up pretty well over the past two years as flatter markets took hold. But in 2016 we’ve seen a noticeable uptick in some of the momentum strategies tracked by Stockopedia, led by the Earnings Surprise screen, which is up 9.5% over the past month.

In line with the research on this phenomenon, the screen rules look for the strongest surprises in both earnings and sales from the most recent results. The table below is for illustrative purposes. It’s a hand-selected snapshot of some of the companies that currently qualify and have also been present in the quarterly rebalanced portfolio over the past 6-9 months. Not all the companies go on to perform well or sustain their momentum, and we wouldn’t necessarily expect them to.

But you do tend to see these smaller, more growth-oriented stocks - companies like accesso Technology and Penna Consulting, which have done very well. We’re currently in peak reporting season, which is obviously a key time for this strategy. So I’d expect to see some chopping and changing in the qualifying stocks over the coming weeks as the data comes in.

The positive performance of the Earnings Surprise strategy in the early months of 2016 is interesting. It’s a strategy very much aligned with fast, sustained growth but also to investor sentiment and confidence in smaller companies. It has undoubtedly picked some winners and for now it’s certainly leading a resurgent performance among some of the momentum screens. The quarterly rebalancing is due at the end of March and we’ll be looking closer at the strategy performances then. But in the meantime, it’s been a good start for companies pulling big surprises. It’ll be interesting to see if that momentum continues.