How To Hunt For Shares Pulling Off The Biggest Earnings Surprises

by: Stockopedia

The equity strategist James Montier, once observed that an enormous amount of evidence suggests that investors are generally hopeless at forecasting. He warned that using forecasts as an integral part of the investment process was like tying one hand behind your back before you start.

While many will agree with Montier's view, there are still ways of taking advantage of company earnings forecasts. One of them is to look for those companies that are actually beating these kinds of performance expectations.

Stockopedia's modelling of a strategy that tracks the biggest sales and earnings surprises in the market has been on a strong run in almost every geographical region over the past year. Stocks tracked in the UK portfolio - which is refreshed every quarter - have contributed to a near 53 percent return over that time.

Worldwide, the strategy has also been paying off handsomely across Europe and in the United States and Canada. It's actually underperformed in Australasia but has bounced back noticeably over the past three months.

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So, what is it that makes this strategy tick?

Why the market loves nice surprises

In many respects, earnings surprises are a holy grail in the stock market. For a start, they make companies and their analysts look good. For investors, they can cause an immediate spike in a share price, and that positive price momentum can carry on for many months.

This rosy picture is supported by academic evidence. Over the past 20 years, research has found that earnings surprises do lead prices to drift upwards over time. It's caused by investors being slow to react to unexpected good news. But as more investors get to grips with the full meaning of an earnings surprise, share price momentum takes over.

Unsurprisingly, there is evidence that companies have cottoned onto this phenomenon. Some suspect that management are cautious in their guidance to analysts to make sure they beat expectations on result day. That may be true for larger companies, but a flick through the research suggests that it's in smaller, cheaper, and less predictable stocks where earnings surprises have the greatest positive impact on share prices.

Among those that have used these rules in their trading strategies are well known students of the market, such as Josef Lakonishok, David Dreman, and Richard Driehaus. To varying degrees, all of them have adopted earnings surprises as an indicator of improving sentiment towards a stock. Some years later, Narasimhan Jegadeesh and Joshua Livnat took it further. Their research found that a more useful indicator in surprises was firms that were beating both their earnings and sales forecasts.

Screening the market for earnings surprises

So, how can you get started with screening for earnings surprises? Stockopedia's ready rolled Earnings Surprise screen is a useful start - but the fixed rules prioritise smaller companies. For more flexibility, this duplicate of the screen has a market cap minimum of £25 million.

In line with the research, it looks for the strongest surprises in both earnings and sales from the most recent financial results. As an example, we've highlighted the biggest recent surprises from both the FTSE 350 and the FTSE SmallCap & FTSE AIM All Share. Here are the top results in each case...

Largest sales and earning surprises in the FTSE 350:

Name

Sales £m

EPS Surprise %, Last Interim

Sales Surprise %, Last Interim

EPS Surprise % Last Yr

Exchange

Lloyds Banking

41,662

294

101.2

10.0

LSE Main

RSA Insurance

6,857

147.7

5.99

22.3

LSE Main

Just

3,924

56.5

24.7

56.5

LSE Main

Ashmore

242.2

47.0

11.2

21.0

LSE Main

John Laing Infrastructure Fund

175.2

46.2

45.1

46.2

LSE Main

Intermediate Capital

625.1

43.1

251.5

13.8

LSE Main

Rolls-Royce Holdings

16,059

35.3

17.0

9.16

LSE Main

Indivior

818.2

32.4

9.89

5.58

LSE Main

Royal Bank of Scotland

13,952

32.0

5.11

48.8

LSE Main

Qinetiq

783.1

27.0

7.12

9.61

LSE Main

Largest sales and earning surprises in the FTSE SmallCap and AIM All Share:

Name

Sales £m

EPS Surprise %, Last Interim

Sales Surprise %, Last Interim

EPS Surprise % Last Yr

Exchange

Ergomed

39.2

126.4

16.8

61.7

AIM

Randall & Quilter Investment

87.8

30.7

19.0

30.7

AIM

Plus500

248.4

26.2

8.26

26.2

AIM

Molins

80.1

23.3

7.52

23.3

AIM

Liontrust Asset Management

51.5

22.6

8.73

10.6

LSE Main

Picton Property Income

54.4

20.0

47.0

20.0

LSE Main

Premier Asset Management

41.8

15.7

17.6

15.7

AIM

Marshall Motor Holdings

1,899

14.0

12.0

14.0

AIM

Premier Technical Services

39.2

12.3

6.65

12.3

AIM

Costain

1,574

10.4

7.50

10.4

LSE Main

Making sense of earnings surprises

While earnings forecasts attract suspicion from some investors, it's undeniable that earnings surprises regularly catch the attention of the market. As part of a strategy, they're a useful pointer to firms that are either recovering from a setback or are consistently advancing ahead. In economic conditions where company earnings trends are under the spotlight, it appears that those beating expectations are being rewarded.

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