Why earnings downgrades are starting to bite

Friday, May 31 2013 by
Why earnings downgrades are starting to bite

Keeping an eye on earnings forecast upgrades by analysts has proved to be massively compelling so far this year. Buying shares with the largest positive earnings revisions is a strategy that’s produced a 38.9% return over the past five months. In spite of the fact that this ‘anomaly’ is so well tracked by investors it continues to be remarkably persistent. But if earnings upgrades are so predictive of positive future returns, should investors be equally interested – or even concerned about – those stocks that have had their earnings forecasts cut? 

According to many academics and market professionals, the short answer to that question is no. Or, to put it another way, the connection between an earnings upgrade and a six- to 12-month rising share price doesn’t exist in the same way between earnings downgrades and falling prices. But even so, earnings forecast downgrades are never good news for companies and with evidence of increasing numbers of them, it’s worth taking a closer look at the impact they have. 

Analysts can cause price momentum 

Over the past couple of weeks I have been writing about the evidence in support of earnings upgrades and how momentum investors can take advantage of them. Many researchers agree that it can take several months for the market to fully price-in the implications of an earnings upgrade, during which time the share price can drift higher. Finance academics Phillip McKnight and Steven Todd have found substantial evidence in favour of this earnings upgrade momentum but much less that the same pattern exists with downgrades. Instead, they believe that bad news travels quickly and investors react very soon to negative events. As a result, instead of drifting, the share price endures a comparatively short, sharp fall. 

In fairness, not everyone agrees that momentum is entirely absent after a downgrade and there are plenty of papers (Jegadeesh and Kim (2005)) connecting negative revisions to short- to medium-term price declines. For that reason we run an Earnings Downgrade Momentum screen which tracks companies that have had their EPS forecasts for next year cut by brokers by more than 5% over the past month. 

Why downgrades matter now 

Technically, Earnings Downgrade Momentum is a short selling screen and as such ought to underperform the market – the shares here are expected to underperform in price. But interestingly, this experimental screen spent…

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