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…

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