Why analysts’ earnings upgrades can help you spot stocks on the up

These forecasts divide opinion, but Ben Hobson argues that they are a useful tool to find company share prices that will grow and grow.

Stocks enjoying meaningful upgrades to their earnings forecasts have been in desperately short supply in recent months. Given the economic uncertainty, it is perhaps no surprise that brokers have been dragging their feet when it comes to making bold upward revisions to their calculations. But there are signs of improvement.

For investors, this is important because material earnings upgrades are among the first signals in the market that something has changed. While many are sceptical about relying on analysts, notable changes in the outlook do tend to be taken seriously. After all, good analysts know the firms they follow better than most. So a change in outlook may well deserve a second look by you.

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Analysts at work

Detailed research and regular access to management means that analysts should be well-placed to work out valuation models and make predictions about future sales and profitability.

While individual forecasts can end up being wrong, many think they are important because the consensus - or average - opinion of analysts can be helpful in predicting company performance. 

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Research over the past 30 years has pinpointed earnings forecast upgrades as one of the most important events connected to analyst research. That is because they have been shown to be a factor that influences the behaviour of investors and can cause upward price ‘drift’ that lasts anywhere up to a year.

The idea is that the market is forced to reassess firms that are getting strong earnings upgrade revisions. Investors have to absorb the news that the stock is performing, or expected to perform, better than expected. If the price is reaching new highs, it can take time for the market to bid it higher - even if it deserves it - and that ultimately leads to price momentum.

In the words of finance professor Aswath Damodaran, this is an example of the theory that markets learn slowly. In his book, Investment Philosophies, Damodaran says events like earnings announcements offer the best support for this idea. He says that one potential explanation is that it takes markets a while to assimilate the information.

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He explains:

“If the initial news was good - a good earnings report or an earnings upgrade from an analyst - you should expect to see upward price momentum. If the news was bad, you should expect to see the opposite.”

Earnings momentum performance

In the four years to the start of 2020, a strategy that targeted stocks with the strongest earnings upgrades performed extremely well. But like many momentum strategies, it suffered badly when uncertainty swept through the market in March. Not only that, but the number of companies seeing these upgrades fell to nearly zero.

More recently, we have started to see the number of companies begin to rise. Unsurprisingly, a number of them come from the metals and mining sector, which has become a safe haven for many investors in 2020. Among the others are the fashion retailers ASOS (LSE:ASC) and Next (LSE:NXT), luxury watch retailer Watches of Switzerland (LSE:WOSG) and the engineering group IMI (LSE:IMI).

Here is how the list looks:

Earnings momentum strategies on the move

While analyst research and earnings forecasts divide opinion among investors, there is evidence that they can offer useful ways of finding stocks on the move. Earning forecast upgrades hinge on the views of analysts and how companies perform against them. These stocks have been shown to benefit from price momentum caused by the market being slow to react to changes in their earnings outlook. 

Momentum strategies do need careful watching, but in a period of huge uncertainty, a strategy like this could be an early pointer to those stocks with the potential to recover.

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