Halloween is a key date in the calendar for those who believe there are seasonal trends in the stock market. It’s the moment when those that had “sold in May and gone away” return for six months of supposedly better performance. Yet, investors hiding behind the sofa this summer missed an 11% rise on the FTSE 100. From here, however, the outlook for earnings has got a great deal murkier in recent months. To combat this, the views of analysts – if you read them right – could help defend against unwelcome horror stories.
One of the main factors currently spooking investors about future earnings is the decline in the value of sterling since the summer. It’s fraying nerves because no-one really knows what the impact on company profits will be next year.
What we do know is that there have been some high profile profit warnings recently – such as NCC, Keller, Cobham and Travis Perkins. And while these weren’t sterling-related, they’re a reminder of the dramatic price falls that occur when a company disappoints on earnings. In these conditions, earnings forecasts are closely watched – but how are they best used?
Forecasting company performance
To start with, there is a lot of research (which we have written about) that shows that broker forecasts and recommendations should be treated with caution. Investors are rightly wary about the credibility of company research and whether analysts are truly objective. Of all the thousands of stock recommendations made each year, only around 10% ever advise selling stocks. In other words, analysts are at best optimistic and tend to herd together for fear of making wayward forecasts. At worst, some argue that analysts are more worried about staying on the right side of company management than giving an objective opinion.
But despite the concerns, studies show that there are ways of reading between the lines of analyst research. One way of doing that is to look closer at those stocks that are attracting the greatest level of upgraded earnings forecasts. Back in 2006 two researchers called Phillip McKnight and Steven Todd, found that portfolios of shares with recent strong ‘earnings upgrades’ routinely produced strong returns. They found that earnings upgrades actually caused investors to take a ‘wait and see’ approach – and that reluctance eventually caused prices to drift upwards for up to a year later.
Very similar findings came out of research led by Brad Barber in 2001. Again, he found that a portfolio of stocks with the most favourable consensus analyst recommendations outperformed. Importantly, though, he found that it was a very expensive strategy because of all the trading costs. But it was useful for investors who were are otherwise considering buying or selling. So, the study showed that a strong consensus view of analysts can be a useful extra consideration when it comes to assessing an investment.
Screening for earnings upgrades
At Stockopedia we’ve seen a strong performance in 2016 from a screen that targets stocks with the highest earnings upgrades – it’s up 26.7% this year. Much of that is down to the fact that it picked up a lot of the earnings upgrades in natural resources companies earlier this year.
The rules look for the highest percentage EPS upgrades over the past three months, looking ahead to the next two years. It also considers how many upgrades there have been compared to downgrades. Stockopedia members can find the screen here.
|Name||Mkt Cap £m||% 1m EPS Upgrade FY2||# 1m Upgrades||# Downgrades (1m)||% Price Target Change – 3 months|
|Jupiter Fund Management||1,984||6.24||13||-||+11.8|
As it stands, the list (this is a snapshot) is still dominated by mining stocks, but others across a range of sectors do creep in. There are some notable upgrades in more cyclical stocks like Boohoo.com and Ladbrokes and the fashion brand Burberry. That’s perhaps a suggestion that analysts think these stocks can resist economic uncertainty and keep growing.
Taking care with forecasts
For investors tempted to listen to analysts and their forecasts, it’s worth remembering that this type of research can be inaccurate. But in market conditions where there is a great deal of uncertainty about future earnings, analysts might be a useful extra guide in weighing up an investment. Reading between the lines and looking for trends in upgrades could be a pointer to stocks and sectors that are best positioned to better weather economic concerns or are enjoying an upturn in their business cycle that may continue.