Momentum is a powerful factor and there is a body of academic work out there that proves this across countries and time periods.

One of these studies, “Analyst Forecasts and the Cross Section of European Stock Returns”, (McKnight and Todd, 2006) is the basis for Stockopedia’s Earnings Upgrades Momentum Screen, which has come to life in recent weeks.

A number of new companies pass the following criteria:

  • % 1m EPS Upgrade FY2 > 5
  • # 1m Upgrades > 1
  • # 1m Upgrades > 1 * # 1m Downgrades
  • # Brokers > 3

McKnight and Todd’s research found that an “earnings upgrade” portfolio materially outperformed a “sell” portfolio - by more than 16% per year.

As for why exactly this might be, McKnight and Todd posited two factors: conflicts of interest in the investment banking industry (leading to unduly optimistic forecasts) on the one hand, and cynical investors adopting a “wait-and-see” approach to good news on the other.

The study’s central insight is that bad news travels quickly, but good news travels slowly. This means that we can sometimes invest after the first upgrade and profit from the upgrades that are likely to follow.

McKnight and Todd also found that stocks with a lower variance of estimates performed better than those with a higher variance of estimates, suggesting that while companies with improving broker upgrades are good, those with improving estimates that are closely grouped together are even better.

So, what are these companies, what’s driving their improving prospects, and should we be re-positioning our portfolios to take advantage of a common trend?

Screening for upgrades

The “Sector” column in the table below gives an instant hint as to what’s driving this re-population of the Earnings Upgrade Momentum Screen:

Name

Mkt Cap £m

Sector

%1m EPS Upgrade FY1

%1m EPS Upgrade FY2

# 1m Upgrades

#1m Downgrades

# Brokers

Lonmin

196.4

Basic Materials

52

18.4

2

0

8

Ferrexpo

1,527

Basic Materials

0.41

14.7

3

0

11

EVRAZ

8,747

Basic Materials

12.7

12.9

3

0

7

Clinigen

1,258

Healthcare

0.41

10.8

3

0

4

GMK Noril'skiy Nikel' PAO

27,041

Basic Materials

8.35

10.0

4

2

11

Cairn Energy

1,023

Energy

-15.3

9.86

2

0

14

Capital & Counties Properties

2,158

Financials

-2.16

9.31

3

0

9

Commercial International Bank Egypt SA

4,302

Financials

3.32

7.34

3

0

10

Anglo American

28,176

Basic Materials

7.68

6.22

13

0

24

The majority of new entrants to the screen over the past month or so are Basic Materials stocks. Rallying copper and gold prices, combined with iron ore supply issues in Brazil, and improvements in Chinese demand due to tighter steel markets are all providing favourable tailwinds in the mining sector right now.

Taking the five miners above and adding in Rio Tinto (which also makes the Earnings Upgrade Momentum Screen) into a temporary portfolio, we can see that these miners are also highly…

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