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Screening the market for companies where brokers have recently upgraded their earnings forecasts has proved to be a great investing strategy this year. Ignoring ‘buy’ and ‘sell’ recommendations in favour of watching for positive changes in analyst sentiment with our Earnings Upgrade Momentum screen has delivered a 36% return over five months. But the recent promotion of food delivery business Ocado (OTC:OCDGF) to that screen raises a couple of interesting questions. With a business model that divides opinion and shares that are a magnet for short sellers, could Ocado be an earnings upgrade Trojan horse?

Last week I wrote about how broker upgrades tend to have a lagging impact on share prices. Rather than just producing a ‘pop’, evidence suggests that the full implications of this type of improving sentiment can sometimes take months to get fully priced-in to a share. This so-called price momentum effect can be triggered by all sorts of events, including upgrades, earning surprises and changes in consensus expectations. But critically, momentum works because investors have been found to react slowly to positive news. Academics Phillip McKnight and Steven Todd, who have studied the impact of broker upgrades, believe this is down to investors adopting a ‘wait-and-see’ approach while they figure out how meaningful the upgrade really is.

For companies to qualify for the Earnings Upgrade Momentum screen, each one needs to have had, in the past month, an earning forecast increase for the next financial year of more than 5%. And with just a few exceptions, all 20 of the shares currently qualifying have enjoyed stellar price improvements in the recent past, contributing to the screen’s impressive performance.

Massive upgrade for Ocado

With a spectacular 222% increase in earnings forecasts in early May, it was little surprise that Ocado shot straight to the top of the screen. Since its controversial IPO in July 2010, when many analysts claimed the 180p flotation price was too rich, its shares have struggled. A spike to 259p in February 2011 was short lived and the stock spent most of last year at well below 100p. Underlying this lacklustre performance is a business that has yet to make a profit from its arrangement to deliver groceries for Waitrose. A long awaited second distribution centre at Dordon in Warwickshire is now operational but sceptics still question whether the business model will ever work profitably.

While it wasn’t exactly a surprise, news last week that Ocado had agreed an online distribution deal with supermarket group Morrisons has thrown even more confusion into the mix. On one hand, the 25-year deal looks very positive for Ocado. Morrisons will pay £170m for the Dordon centre, equipment and licences and another £46m to expand the site. That was enough to drive the share price up to 285p earlier this week (it is curently trading at 264.8p).

But detractors are concerned that Waitrose will react negatively to this deal; either stifling it or cancelling its own contract. And, even then, it still doesn’t entirely prove that the outsourced delivery model works or that the market is valuing Ocado correctly. You only need look at broker target prices for the stock to understand the scale of all this uncertainty. Many of them have consistently downgraded their views on Ocado since the IPO, with HSBC notably bearish with a current target price of 95p. Despite that, earlier this month, and prior to the Morrisons announcement, Ocado was upgraded by Goldman Sachs, which more than doubled it target price to 300p, as well as BNP Paribas, which raised its target from 225p to 300p. It was those lofty upward revisions that propelled Ocado on to our Earnings Upgrade Momentum screen and, pleasingly, the soaring stock has been a welcome addition … so far.

It’s worth noting that Ocado shares have long been popular with short sellers who until recently were wagering as much as 15% of the available stock on it continuing to disappoint the market. This month the short positions have declined slightly and the subsequent ‘squeeze’, where shorters are forced to actually buy the shares in the market, possibly provided short-term stimulus to the price. Earlier this week, deep value and special situations investing blogger MrContrarian, adeptly summed up the situation by saying: “Ocado sautéing shorters in Président butter with garlic, cilantro & jam (tomorrow).”

Even so, Ocado remains the third most shorted stock in the FTSE 250, with hedge funds like Jim Chanos’ Kynikos Associates and GMT Capital Corp. still heavily selling the shares. A quick look at our James Montier-inspired "Unholy Trinity" screen suggests that the company remains a potential short sell candidate. These smart money investors are often proved to be right so a major question that arises is whether they will now find even more appeal in selling Ocado stock or whether the business can attract increasing numbers of long-only holders.

What does all this mean?

Prior to the arrival of Ocado the Earnings Upgrade Momentum screen was performing handsomely on its own. Willingness by a couple of brokers to upgrade their forecasts and Ocado’s subsequent share price appreciation have been a real boost to the screen. However, the uncertainty surrounding the company’s model, the impact of the deal with Morrisons and the skewed effects that short selling could have had on the share price are all causes for concern. While evidence suggests that Ocado’s shares could benefit from some momentum in the coming months because of its recent broker upgrades, it seems clear that really nobody knows where this stock will head next.

Source: Ocado Boosts Our Earnings Upgrade Screen - But Is It Time To Worry?