10 great companies that are beating forecasts

Positive earnings surprises are not what you’d expect heading into a recession, but stock screen expert Ben Hobson says this strategy pinpoints firms better able to resist pressure and those that can bounce back quickly in a recovery.

Earnings expectations are crucial when it comes to valuing shares and judging company performance. But in recent years, issues such as Covid and economic headwinds have made it trickier than normal to predict how firms will fare.

But, as we start to look beyond the current challenges, keeping an eye on positive earnings surprises could be one way of finding early winners in a recovery.

Three years when forecasts went out the window

When the stock market crashed in February 2020, it was partly because future company profits (or earnings) had suddenly become more unpredictable than usual.

• Find out about: Transferring a Stocks & Shares ISA  | Share prices today | Top UK shares

With Covid sweeping the world, it was clear that economies were closing down, and companies quickly responded by ditching their earnings guidance.

One study that went on to examine UK market announcements in the early phases of the pandemic found more than 50% of companies “regressing to silence, disclaiming to provide guidance or not providing a forecast.”(1)

And it wasn’t just the UK. In the US, where companies report their figures every quarter, there was a spike in firms undershooting their earnings expectations in the first quarter of 2020. That was because forecasts and reality were out of kilter.

By the second quarter, many firms had reassessed the outlook and issued new guidance. Even though Covid was hurting profits, the new forecasts gave the market some direction, which ultimately spurred a recovery.

Two years on, Covid doesn’t pose the same threat to earnings that it once did. But its impact, and the economic turmoil that companies now face, are still making life difficult when it comes to forecasts.

With a possible recession looming, some worry that consensus expectations are too optimistic. There is concern that analysts haven’t adjusted their figures enough to take account of trouble ahead. But others think that if inflation softens next year we could be in for better times.

All eyes on earning surprises

While company earnings are never a sure thing, one event that is certain to capture the imagination of investors is a positive earnings ‘surprise’.

When companies deliver sales and profit numbers that beat expectations it can have a surprisingly long-lived impact on share prices. Not only will prices rise, but those rises can persist over time.

• World Cup winners: 10 shares investors might pick for their team
• Stockwatch: big drop in price makes this share interesting

Researchers have described this ‘slow burn’ phenomenon as ‘post-earnings announcement drift’. It is believed to be caused by the market being slow to price-in better-than-expected financial performance.

Until recently, the price momentum caused by earnings surprises was thought to be governed by the size of the surprise. But recent research suggests that if you really want to profit from earnings surprises, it’s worth focusing on the quality of the company’s earnings too.

Earnings you can depend on

One of the problems with earnings is that they can be manipulated with a bit of accounting trickery. That makes it more than possible to choreograph an earnings surprise.

Research by the investment bank Morgan Stanley aimed to reduce this risk with a strategy for finding earnings surprises in healthy firms with both good quality profitability and rising revenues.

When it comes to quality, they suggest looking for a track record of stable profitability, low debt, good cash conversion and low accruals. What that means is that the strategy looks for firms where a high proportion of earnings turn into real cash flow (rather than being stuck as non-cash earnings). Earnings that turn to cash can be a strong pointer to higher-quality businesses.

Likewise, the strategy looks for revenue growth and better-than-expected revenue performance. This can also be a pointer to firms whose products are in demand.

Earnings surprises are not what you’d ordinarily expect with an economy on the cusp of recession. But this could be a useful strategy that pinpoints firms better at resisting pressure, as well as those with potential to bounce back quickly in a recovery.

In this strategy we’re looking for shares where:

• Both sales and earnings beat consensus expectations by more than 5% last year
• Operating margins and Return on Capital Employed are more than 10% on average over five years
• Accrual ratios are less than zero (indicating that earnings turn to cash)

Data: Stockopedia.com

Despite the economic uncertainty over the past year, these companies have managed to produce sales and earnings surprises. That might not continue - but it’s an interesting starting point in finding firms where momentum might be building.

There is a financial theme here, with asset managers such as Man Group (LSE:EMG), Premier Miton Group (LSE:PMI)and Liontrust Asset Management (LSE:LIO)passing these quality rules.

Equally, this mixture of earnings momentum and good quality earnings shows up in small firms such as OPG Power Ventures (LSE:OPG) all the way up to large-caps such as Mondi (LSE:MNDI)and SSE (LSE:SSE) - so it really does open up the whole market.

A barometer of the market

Forecasts of future company earnings are a critical component in the way the market prices shares and analyses company performance. After all, prices today are based on expected earnings tomorrow.

What we have seen over the past three years is how the market can lose its way when the earnings outlook is suddenly plunged into uncertainty. We can also see how expected economic headwinds can cause friction in analyst forecasts.

• Explore more of our content on UK shares
• Investment forecast for 2023: hot sectors, income and growth

Rather than worrying about the accuracy of forecasts, a more practical strategy might be to look for firms that are beating forecasts. It’s here where companies are performing better than expected, so they demand attention. It’s a source of ideas for firms that might be able to keep outpacing expectations.

If you can find these earnings surprises in firms with high quality financials, it could be a clue to finding those with genuine momentum behind them.

(1) (Brennan, Edgar, Power (2022). COVID-19 profit warnings: Delivering bad news in a time of crisis)

Ben Hobson is a freelance contributor and not a direct employee of interactive investor.