11 shares where positive earnings shocks could trigger rallies

Companies that beat their sales and earnings forecasts can be well rewarded on results day. Beating targets often leads to favourable headlines, cheers from investors and rising share prices.

For onlookers, the sight of a stock that's soaring on unexpected good news can seem like a missed opportunity. But there's evidence that these firms often have much further to go.

The trouble with forecasts

Part of the confusion surrounding sales and earnings surprises is that they're found in a murky area of the investment map.

For a start, there's a sense that the analysts who make these forecasts can be compromised by being too close to company executives. Suspicion surrounds the possibility that management can 'walk up' or walk down' their guidance to analysts. In doing so it would be possible to orchestrate positive surprises.

Some are also sceptical about whether analysts are any good at forecasting future sales and earnings. Poor forecasting makes it difficult for investors to tell the difference between genuine outperformance and whether the analyst has simply got their sums wrong.

In addition, there are those who feel that the market actually does a pretty good job of anticipating surprises - especially when companies do it frequently - which of course means they are no surprise at all!

Taking advantage of momentum

Despite these objections, research shows that companies that surprise the market by beating consensus forecasts do tend to see their prices go higher over the following three-to-six months.

One of the reasons for this 'post-earnings announcement drift' is that investors and analysts are slow to re-adjust their assessments and expectations of a company. Put simply, the surprise forces them to revisit their assumptions - and that takes time.

Not only that, but stocks catapulted by earnings 'beats' cause some peculiar behaviour among investors. On one hand, outsiders are reluctant to buy shares that have already risen strongly in price. By contrast, those that already own those 'winning' shares tend to sell them too quickly for a profit.

In combination, these factors can stifle the market's ability to price the shares correctly. But as the weeks pass, and investors get to grips with the full meaning of the earnings surprise, they buy into the shares and the price gathers momentum.

To take advantage of this potential momentum, there is an important extra consideration. Academic research has shown that it's well worth looking for companies that outperform on both earnings and sales. This is crucial because potentially troubled companies can bolster earnings by cutting costs, temporarily masking what could be bad news in the future. But growing profits in tandem with sales is a much stronger signal.

Where we're seeing the biggest earnings surprises

Momentum investing strategies did well during the very bullish market phase in 2013. They've also held up pretty well over the past two years as flatter markets took hold. But in 2016 and into 2017 there has been a noticeable uptick in momentum strategies that use earnings surprises. One strategy portfolio tracked by Stockopedia has risen in value by 24% over the past year.

In line with the research, the strategy rules look for the strongest surprises in both earnings and sales from the most recent financial results. We've highlighted the biggest recent surprises from both the FTSE 350 and FTSE AIM All-Share.

Largest sales and earnings surprises in the FTSE 350:

Largest sales and earnings surprises in the FTSE AIM All-Share:

One of the notable trends in the FTSE 350 results is the sales and earnings surprises among financial and insurance stocks. Among them are RSA Insurance, Royal Bank of Scotland and Hiscox. In the AIM All-Share, the results are more mixed, with recent surprises coming from drug development services firm Ergomed, mining company Griffin Mining and litigation finance business, Burford Capital.

While earnings forecasts attract suspicion from some investors, it's undeniable that earnings surprises often catch the attention of the market. As part of a strategy, they are 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.

About Stockopedia

Interactive Investor's Stock Screening series is written by Ben Hobson of Stockopedia.com, the rules-based stock market investing website. You can click here to read Richard Beddard's review of Stockopedia.com and learn more about the site.

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About the author

Ben Hobson is Investment Strategies Editor at Stockopedia.com. His background is in business analysis and journalism. Ben researches and writes regularly on investment strategy performance and screening ideas for Stockopedia.com. He is the author of several ebooks including "How to Make Money in Value Stocks" and “The Smart Money Playbook”.