Why it can pay to accept the discomfort of buying stocks hitting new highs

There are very few stock market signals that catch the attention of investors quite like the 52-week high. Lists of shares making new highs are published in newspapers and on websites around the world every day. But while 52-week high data is easy to get hold of, what does it really tell you and how can you make the most of it?

One of the surprising traits of the 52-week high is that it can have a major impact on the minds of investors - and sometimes that makes it more of a hindrance than a help.

While the information is readily available, evidence shows that it can cause a kind of momentary paralysis in investors that leads to a slow reaction in prices. And when you get the extra kicker of a positive earnings surprise from a stock that’s trading at a 52-week high, this so-called ‘post-earnings announcement drift’ has been shown to be even more extreme. But while all this sounds quite negative, it arguably creates an opportunity for investors who are aware of it.

The lowdown on new highs

I cover the subject of 52-week highs periodically, and it’s one of those areas that provokes a lot of interest. For a start, new highs have the credibility of being used by popular investors like Mark Minervini and William O’Neil. Yet when you look at the research into new highs, the explanation for why they’re important is quite intricate.

Influential research on them was published by Thomas George and Chuan-Yang Hwang in 2004, which found that they were a major driver of momentum. Momentum is the tendency for price trends to persist over the short to medium term, and it’s often linked to how investors think and behave.

George and Hwang reckoned that investors used the 52-week high as a reference point, or anchor. They found that when new-news comes along about a company, it can take days, weeks or even months for the price to shift upwards because of this ‘anchoring’ effect. In essence, existing investors are simply slow to bid the price higher, while onlookers are reluctant to buy at the new high. This is where the term post-earnings announcement drift comes from.

Now this kind of investor irrationality isn’t restricted to 52-week highs. There are other events that cause investors to hesitate that have also been linked to momentum. One of them is the ‘earnings surprise’, which is a classic example of a stock market event that can throw investors into turmoil. In this case, better than expected news can actually make investors slow to bid prices up. To get to grips with this, we last covered earnings surprises here.

Mixing new highs and extreme surprises

While the 52-week high and earnings surprises are both components in Stockopedia’s Momentum Rank, what you often find is that they’re treated as separate events. But this shouldn’t be the case at all. It makes sense that a stock trading at a new high is capable - and even likely - to produce an earnings surprise. In fact that’s exactly what we’ve seen in high performing shares like Boohoo.Com and Fevertree Drinks over the past year. In those cases, broker estimates couldn’t keep up with each company’s earnings momentum and they just kept hitting new highs.

To bring this full circle, the most recent academic evidence supports the view that post earnings announcement drift is most extreme when you get stocks trading at 52-week highs and delivering earnings surprises.

This is exactly the conclusion of a follow-up 2015 paper by George, Hwang and Yuan Li. Their research found that, on average, companies that issue extreme positive surprises see more muted share price action the closer their prices are to their 52-week high. But crucially, this corrects itself over time and the prices of these shares rise much more strongly on subsequent announcements.

So the lesson for investors, as far as this evidence goes, is that it can pay to accept the discomfort of buying stocks hitting new highs - especially when they’re beating earnings expectations, too.

Putting new highs and earnings surprises to work

At Stockopedia, we track momentum strategies that focus on both 52-week highs and earnings surprises. So it’s simple to take the key features of both and combine them in a new screen - which subscribers can find here.

In terms of rules, this screen looks for shares ranking in the top 10 percent in the market based on how close they are trading to their 52-week high. Those companies must also have produced an earnings surprise of at least 5 percent at the last half or full year results (we’re ideally looking for extreme surprises). In this case we’ve excluded financial stocks and set a minimum market cap threshold of £25 million.

Right now, one of the interesting features of the list is that the stocks on it span a wide range of market caps. The highest achiever based on proximity to the 52-week high is one of the smallest stocks, Robert Walters, which beat earnings forecasts by just over 7 percent in its most recent numbers. But it’s chased by much larger companies, including B&M Retail, BCA Marketplace, Next and JD Wetherspoon. But care is needed - the next stock on the list is Quantum Pharma, a pre-profit drug developer that is hitting new highs but is bouncing back from a low level. So as ever, it’s worth digging into the details with this kind of screen.

Considering that the 52-week high is one of the most accessible data-points about a share, it offers some interesting insights. The momentum effects that are triggered by new highs have been found to be powerful and can continue to drive prices higher over many months. Combined with another momentum driver - strong positive earnings surprises - the most recent research points to a more pronounced upward drift in prices over time. Buying shares hitting new highs is undoubtedly a tough strategy for some investors, but the evidence still points to momentum being one of the most powerful drivers of returns in the market.