How you can catch the FTSE breakout by surprise

After a lacklustre performance last year it looks like the brakes have been released on the UK's mid and large cap indexes. The FTSE 100 and FTSE 250 have enjoyed respective gains of around 7.2% and 9.4% so far in 2015. After 12 months of gazing enviously across the Atlantic at soaring US stock markets, it appears that these UK wallflowers are taking to the floor.

For investors considering ways of riding this recent momentum it could be worth taking note of those stocks that pulled off the biggest earnings surprises this earnings season. While broker forecasts can be notoriously inaccurate, research shows that stocks that beat earnings estimates by wide margins often see their prices rise over the coming months (and they tend to keep on surprising, too).

Momentum triggers

Academics observed this type of 'earnings momentum' as far back as the late 1960s. Like other momentum triggers - such as earnings forecast upgrades and 52-week highs - it's thought that positive surprises are insightful because they prod at the behavioural flaws of investors and analysts.

In a nutshell, onlookers tend to react slowly to the full implications of a surprising financial performance. Studies that have found that company analysts can take as long as six months to incorporate earnings and revenue surprises into their forecasts. This tardy response creates so-called post-earnings announcement drift, where share prices often take a period of between three and 12 months to fully reflect the earnings news. Not only that, but some evidence suggests that companies that have surprised the market in the past are more likely to do so again in the future.

Earnings surprises were famously employed as buy and sell signals by US investor Richard Driehaus, who delivered compound annual returns of 30% in the 12 years after starting his fund in 1980. More broadly, a 2008 study by Elroy Dimson, Paul Marsh and Mike Staunton of the London Business School found that momentum in general had been a consistently profitable strategy for over a century despite periodic reversals of fortune. So investors should take note.

Our screening of the market focused on the greatest percentage earnings surprises for the last financial year. We set a minimum ValueRank filter of 50/100 to strip out the most expensive shares and included the overall StockRank as a guide to each stock's quality, value and momentum characteristics. We also included AIM shares.

Topping the list is Burford Capital, a company that provides 'litigation finance', essentially deploying investment capital to assist its business clients cover legal fees and expenses. The AIM company reported a large uplift in earnings recently - up 111% to 23 US cents per share. That in turn forced a substantial increase in forecast EPS for 2015 from its brokers (see chart). Among the largest companies here are real estate regeneration group St Modwen Properties (beating consensus earnings forecasts by 39%), wealth manager St James's Place (+24%), set-top box maker Pace (+13.4%) and housebuilder Redrow (+11.7%).

The general trend among the forecast-beaters on this list is that the smaller companies have the highest StockRanks. Accident management company Redde overshot broker estimates by 22% last year, forcing upgrades from brokers for 2015 (see chart). Redde has a StockRank of 95. Wood distribution business James Latham beat forecasts by nearly 14% and has a StockRanks of 99, while earnings at engineering services group Costain came in 12% ahead of expectations, and it also has a StockRank of 99. And as for Dart, its recent earnings beat sent its price soaring by 18% on the day - as Ed wrote about here.

Spoiling the surprise?

It seems counter-intuitive to question the credibility of earnings surprises but critics have argued that both company management and even analysts can deliberately 'walk down' estimates to ensure a surprise on results day. For that reason it's worth looking for the very biggest surprises and ensuring that stocks haven't already become overly expensive. After all, the combination of value and momentum - two uncorrelated factors - is regarded by academics and some fund professionals as a highly effective strategy. So in looking for ways to trade on increasing confidence in the market so far this year, earnings surprises could be a place to start.

What do you think? Is the strong start to 2015 likely to continue? And what about the smaller caps - AIM has had a quiet start to 2015, but will it eventually benefit from bullish sentiment elsewhere in the market?

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