Earnings Momentum: Beating Analysts At Their Own Game

With company earnings season in full swing and London markets displaying signs of improving confidence, we thought we’d share the impressive performance of one of our Momentum screens, which tracks those companies that analysts think are poised for a surge in earnings. 

Of course, as we have discussed in the past, paying too much attention to what analysts have got to say about company stocks is fraught with risks. Broker recommendations (produced by in-house teams of analysts) on whether clients should buy, sell or hold stocks are widely reported in the media but the value of these recommendations is hotly debated. Indeed, research tends to suggest that stock pickers who follow broker recommendations too closely are on a hiding to nothing! 

However, amid the barrage of broker notes and reports, there are a few nuggets of information that can prove useful – earnings upgrades. Scrutinising the market for stocks that are attracting growing confidence among analysts is arguably a far more effective way of using all this information. To support that claim, our Earnings Upgrade Momentum Screen is currently flying – outperforming all of our 63 screens and up an astonishing 31.6% since last December against 11.1% for the FTSE 100.

The problem with brokers 

Among seasoned investors and academics alike, the issue of broker recommendations has a habit of dividing opinion. Research by Jegadeesh, Kim, Krische and Lee over the period 1985-1999 found that sell-side analysts rarely made strong-sell recommendations and this chimes with the theory that analysts have historically exhibited a strong upward bias. This is because most sell-side analysts work for brokerage houses which often have strong investment banking franchises, creating a potential conflict of interest when firms act as investment bankers to the companies their analysts cover. 

Since that research was conducted a raft of legislation has been introduced on both sides of the Atlantic – including the EU’s Markets in Financials Instruments Directive (MiFID) – to try and fix the problem. Although this appears to have had some impact, recommendations have still remained relatively optimistic, with research by Jegadeesh and Kim in 2006 indicating that analyst recommendations retain a significant element of favourable bias. 

But hang on… 

Rather than scrutinising every word of broker recommendations, investors could do better by watching for when these analysts have a change of heart. Indeed, research suggests that focusing on recent changes in broker recommendations is more fruitful, particularly in combination with other signals, and help to eliminate the upward bias. It also ensures that the information is fresh, unlike recommendations which can be up to six months old. 

Research on European stock by Todd & McKnight found that the positive returns realised on an earnings upgrade portfolio were large and persistent, whereas the sell portfolio generated a near zero return, i.e. the bad news was quickly priced in whereas the good news diffused slowly. This may be because conflicts of interest encourage analysts to report overly optimistic earnings, and investors, aware of these biases, respond by being cynical and adopting a “wait-and-see” approach when it comes to good news. 

How the screen works 

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To qualify for this screen, companies must be covered by more than three analysts. Thereafter, the key metrics are: 

• Each company’s earnings per share estimates for the following year should have been increased by more than 5% during the previous month 

• There must have been at least one upgrade during the previous month, and 

• The number of upgrades during the previous month must be higher than the number of downgrades

So which companies are in the list? 

It’s important to remember that, like most of our screens, these approaches tend to be best at the portfolio level, i.e. a given company may do badly while the basket does well. Still, it’s interesting to look at a few of the key names on the list of 27 stocks that make up the Earnings Upgrade Momentum screen. 

First up is paper and packaging group Mondi (LON:MNDI), where analysts have upgraded the EPS forecasts by 15.8% for next year. Expectations on the figures had waned during the latter half of last year but there was an uptick in sentiment last month, with six upgrades. Indeed shares in the £3bn market cap group have been racing since the start of the year. That has all been helped by positive sounds from the group on improving trading conditions, stronger order books and signs that prices in some of its markets are improving. 

Elsewhere, opinions among analysts of media group ITV (LON:ITV) are well divided but earnings momentum has gone in the company’s favour of late, with a 9.44% increase in EPS forecasts during the last month and a heady 18 individual upgrades. For its part, ITV recently announced a 24% rise in annual profits of £398m and despite warning that overall advertising sales were likely to dip in the coming year, it said it was confident of outperforming the market. 

Finally, one interesting name on the list is Max Petroleum (LON:MXP), the oil and gas E&P group with operations in Kazakhstan. Max is the only oil and gas play on the list and its presence reflects its transition from exploration, appraisal and development (although still ongoing) towards increasing production. Overall, Max’s EPS figures for next year have been increased by 36.4% over the last month, with two earning upgrades and one downgrade during the last month. However, what’s interesting is that Max’s EPS forecasts are actually down 35% over the last three months, so it rather depends over what time frame you assess momentum. The research seems to suggest that the market catches up over longer time frame, so our inclination is to not amend the criteria, but it’s an interesting question. And we’re probably partly swayed by the impressive performance of this screen to date - if it ain't broke, don't fix it!

You can see the full list of qualifying Momentum Stocks here. As ever, though, it’s important to do your own research on any set of screen results. 

Reflections 

So far, there can be little argument with the performance of the Earnings Upgrade Momentum screen. It has outperformed absolutely everything else (Slater, Buffet, Graham, you name it) since we started tracking it last December. Will it be sustained? Interestingly, on the other side of the Atlantic, the American Association of Individual Investors has seen vast outperformance from a similar screen over a much longer period. 

Finally, it is worth noting that investors could benefit by applying additional filters to the screen to tighten the criteria even further. For instance, the research suggests that the time lag for the market to respond to good news may make it worth watching companies with relatively low analyst coverage. Likewise, bold analyst revisions, which move away from consensus, or even upgrades that skip ranks – such as from ‘hold’ to ‘strong buy’ could also be worth watching.