11 shares brokers back to deliver even bigger profits

There's a view in some parts of the stockmarket that earnings forecasts aren't worth the paper they're written on. The argument goes that most company directors can't predict what will happen next month - so how can analysts make accurate profit forecasts two years out?

Yet, despite the criticism - as I mentioned in last week's column - earnings forecasts are generally taken pretty seriously by investors. That's because they're one of the few sources of guidance about how a company might go on to perform.

But there are other ways of using earnings forecasts to an advantage. In particular, these figures can be a useful way of detecting earnings trends not just in specific companies but in entire sectors, too.

• 10 shares to watch for big earnings surprise

Understanding how analysts work

Analysts are trained to have a deep understanding of the quoted companies they cover. Detailed research and regular access to management means they can work up valuation models and make predictions about future sales and profitability.

But while individual forecasts can end up being wrong, many think these predictions are important because the consensus - or average - opinion of analysts is one of the only ways of predicting company performance. In other words, it's the best (or perhaps least-worst) way for individual investors to gauge how a stock is likely to perform.

Academic research over the past 30 years or so has highlighted earnings forecast upgrades as one of the most important events connected to analyst research. That's because they have been shown to cause behavioural turmoil among investors that leads to prices drifting for up to a year.

The idea is that companies receiving sharp increases in earnings forecasts lead the market to reassess them. Investors have to absorb the news that the stock is performing, or expected to perform, better than they previously thought. If the price is reaching new highs, it can take time for the market to bid it even higher - even if it deserves it - and that ultimately triggers 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.

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 strategies are outperforming

Over the past year, investing strategies that actively seek out earnings forecast upgrades have been performing well. Over that period, we've seen a 25.7% return from this strategy, which specifically looks for at least a 5% increase in consensus earnings forecasts for the next financial year during the past month. Here's a snapshot of the current list:

One of the interesting features of the current list of high earnings upgrades stocks is that it contains a number of natural resources companies. Mining firms like Vedanta Resources, South32 and BHP Billiton have not only seen substantial profit upgrades, but they've also seen sharp rises in the number of analysts actually upgrading them. It's a similar story for oil groups like Cairn Energy and Royal Dutch Shell. In amongst them are firms like hire chain HSS Hire, sports betting and gaming group GVC:GVC and support services business Restore.

Name	Mkt Cap £m	% 1m EPS Upgrade FY2	# 1m Upgrades	# 1m Downgrades	# Brokers	Sector
Vedanta Resources	2,035	31.9	3	1	5	Basic Materials
HSS Hire	53.9	25.2	2	-	4	Industrials
Cairn Energy	1,340	24.4	5	1	15	Energy
GVC Holdings	5,253	23.7	2	-	6	Consumer Cyclicals
Tharisa	302.7	22.2	2	-	4	Basic Materials
Hochschild Mining	1,080	21.8	3	1	6	Basic Materials
South32	10,092	8.93	11	1	17	Basic Materials
BHP Billiton	82,942	7.74	11	2	22	Basic Materials
Restore	614.6	7.18	2	-	4	Industrials
Drax	1,201	6.47	2	-	10	Utilities
Royal Dutch Shell	213,518	5.78	8	-	18	Energy

Source: Stockopedia                  Past performance is not a guide to future performance

Earnings momentum strategies on the move

While analyst research and earnings forecasts divide opinion among many investors, there is evidence that they can still offer useful ways of finding stocks on the move. Earnings 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 the upbeat conditions we've seen over the past year these approaches have worked very well.

About Stockopedia

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

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It's worth remembering that these and other investment articles on Interactive Investor are simply for generating ideas and if you are thinking of investing they should only ever be a starting point for your own in-depth research before making a decision.

*No fee for publication is involved between Interactive Investor and Stockopedia for this column.

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"

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