One of the first things I learnt when investing was to ignore news issued by the businesses I invested in. News would be taken account of immediately by the market. Bad news often meant an opportunity to buy a business at a cheaper price as it would already be baked and into the price and, provided the business was good, the bad news was likely to be temporary. This seemed to make sense at the time and appealed to my desire to be smart and ‘contrarian’, but like pretty much everything I learnt from reading beginner value investing articles at the time, it was terrible advice.
I’ve found overwhelmingly from my experience since then that buying shares soon after they issue positive news leads to outperformance (and vice versa). As I have later found, there is a huge wealth of academic research supporting this too.
The idea behind trading news flow is pretty simple – it is to buy shares where there is a positive surprise, for example better than expected earnings (profits) or an ‘ahead of expectations’ trading update, and to sell on a negative surprise, like a profit warning.
The logic behind this strategy is that share prices tend to underreact to new information and so continue to rise for some time after a positive announcement. In a world where information is free and easy to access, and where there are countless professionals using improving technology to look for profitable ways to exploit investing in stocks, it is surprising that this feature persists. But it does and there is a lot of evidence to support it…
Evidence that it works
There is a lot of academic empirical evidence that buying shares just after positive news statements is profitable (sometimes this effect is referred to as earnings momentum or post-earnings announcement drift). For example:
- Empirical evidence that the post-earnings announcement drift exists (Pope and Brown 1996)
- Both price and earnings momentum independently contribute to outperformance (Chan, Jegadeesh and Lakonishok 1996)
- Post-earnings-announcement drift represents an underreaction to earnings information and arbitrage risk impedes arbitrageurs from eliminating it (Richard Mendenhall 2002)
- Price, revenue and earnings surprises each individually lead to outperformance and combined even more so. The information conveyed by revenue surprises and earnings surprises combined account for about 19% of price momentum effects (Chen, Chen, Hsin and Lee 2014)
There are many other papers all finding evidence of this effect. There is some variation in this research as to whether it works better in different countries and to what extent it applies only to less liquid stocks. As I say above, my own experience is that it tends to work well when applied to the kind of investments I look at – small, high quality, relatively illiquid, growth stocks.
Why it works
I haven’t found any clear evidence explaining exactly why this effect exists. There are likely a multitude of reasons and it is difficult to find convincing evidence supporting any of them individually. But there are some features of the stock market and investor behaviour that to me seem likely to be the main sources of earnings momentum.
The first is the role of liquidity, or rather illiquidity, in share prices. For the market to be efficient, a sufficient proportion of market participants need to respond to changing price signals quickly. However, at any given time only a small minority of market participants may be active in the market. Consequently, some shares are very illiquid, in that there is a thin volume traded, and this makes it difficult to buy or sell a large volume of shares without very substantially affecting the market price. When buying a position in an illiquid share, large institutional buyers will often have to stagger purchases over time to wait for sellers to come to market. This means that prices can take some time to respond to news.
A key feature of illiquidity is that it affects large and small investors asymmetrically. By this I mean a small private investor looking to invest a few thousand pounds is unlikely to find liquidity an issue for most shares, while a large institutional investor with millions to invest is likely to find that it takes a long time to buy and sell its positions. Institutional investors often sell into strength and buy into weakness, as this is the only way they can establish positions in less liquid shares without affecting the price too much. Illiquidity forces them to take a medium to long term perspective and restricts them from responding to newsflow. As a small private investor, the greater liquidity is a massive advantage.
The other main reasons I am aware of for earnings momentum are behavioural i.e. because collectively investors in the market make systematic errors in their decisions. There are a plethora of behavioural reasons for earnings momentum – most of them are the same as those for price momentum and I have written about some of them previously. The more important ones in my view are probably:
- Anchoring – the idea that decisions are anchored by the current price. A rise in price to a new high makes a share look expensive, even where excellent news means an even greater rise is merited.
- Regret aversion – people are very averse to the feeling of regret and will be biased to take actions that avoid it (even if it costs them). This is relevant for earnings momentum because some investors may be reluctant to buy a company when the price has risen following positive news, as this can causes them to regret not having bought into it earlier. It is less psychologically costly to subconsciously avoid and move on to something else.
Another point about a positive earnings surprise is that it likely to be positively correlated with other benefits for the business beyond just the increased earnings. Success tends to breed success. An earnings surprise often means further outperformance in the future is now also more likely and profit warnings are less likely. These wider implications may not be immediately appreciated by all investors, contributing further to earnings momentum.
How to exploit newsflow
As a small investor, it pays to pay attention so you can respond to newsflow quickly. While post earnings announcement drift can last for weeks or months after an announcement, typically the sooner you get in there the better. To do this I think it helps a lot to monitor a watchlist of shares. There are quite a few internet based providers of services that provide alerts when a share on a watchlist issues and RNS. I use Investegate for this and have a quick look every morning between 7 and 8 to see whether there are any buying opportunities for the shares on my watchlist (as well as keeping an eye out for profit warnings for the shares already in my portfolio). To be clear, I wouldn’t invest in any old share issuing a positive news statement. Rather I use news flow as an indicator of good buying opportunities for the shares that I have identified for my watchlist based on their high quality.
Once you have an alert system set up it should be reasonably easy to identify positive trading updates and earnings surprises. However, there are a few things to take into account when interpreting them.
All about expectations
Whether a positive news statement is in fact a surprise depends of course on what the expectations of other investors are beforehand. Analyst forecast estimates are in my opinion generally a pretty good guide to market expectations. The research finding evidence of post earnings announcement drift uses analyst forecasts, so if you hope to capitalise on this effect you shouldn’t go too far wrong by focusing on shares that beat analyst forecasts.
However, there is a bit of nuance to this. Analysts can often be conservative in their forecasts or slow to reflect improving performance and this can become obvious to investors. Insofar as performance exceeding analyst expectations is anticipated by the market beforehand, there will be less of an impact on the share price when the news comes out. Sometimes prices can even fall on positive news as investors anticipating the news take profits. Hence the classic adage: ‘buy the rumour, sell the fact.’ I think fully anticipated earnings ‘surprises’ are more the exception than the rule, but it probably pays to be a bit careful and stick to situations where the positive news clearly exceeds market expectations to an extent that the market is unlikely to have anticipated.
What statements say
Interpreting results statements and trading updates is more of an art than a science. It is at one level fairly straightforward – the idea is to get a sense of what a statement implies about a company’s performance relative to expectations. Often this is mentioned explicitly. However, in interpreting statements it’s important to take account of management’s desire to come across positively – more often than not quite negative statements will also have a lot of positive spin. To deal with this my approach is not to compromise at all – I look for news statements with unbridled enthusiasm and evidence to back it up, ideally from cautious management.
Companies are obliged to update when it becomes clear that trading is significantly better or worse than expectations, so the first point at which this becomes known in my experience tends to be a trading update in advance of the results rather than the themselves (though it can be either). The timing of trading updates sometimes follows the same pattern each year for some companies but more often the timing is unpredictable, especially if a trading statement is made because the company is trading unexpectedly well (or badly).
Trading updates are generally quite short and easy to interpret – the company will say how it is performing relative to expectations. This is often described a bit cryptically, using terms like the following instead of actual numbers:
- In line with expectations
- Broadly in line with expectations i.e. just below
- Comfortably in line with expectations i.e. just above
- Ahead of expectations: this can be ‘materially’, ‘significantly’, ‘substantially’ or ‘comfortably’ ahead. There is not really a consistent common definition for what these terms mean exactly in terms of degree but in my experience the latter two tend to mean more ahead than the former two. Note that ‘comfortably ahead’ can mean something quite different to ‘comfortably in line’ – at least this has been the case in my experience.
- Below expectations i.e. a profit warning
Sometimes trading updates do not explicitly refer to expectations i.e. they might just say something like ‘trading is progressing well’ or ‘the business is looking forward with optimism’. This can be a bit unhelpful. I am always inclined to be a bit sceptical if expectations are not specifically referred to in a trading update, unless the tone is very positive. I would look back at previous updates to see if expectations were mentioned and, if they were, I would be particularly wary of their omission in this update.
I am also very wary if the tone of the statement is mixed. For example, ‘we are optimistic about meeting market expectations despite some difficulties at division A…’ would set alarm bells ringing for me. This sort of statement would suggest to me that the risk of a profit warning has substantially increased.
Results statements contain a lot more information than trading updates and so are typically more difficult to interpret. If a trading has recently been provided there is often not much in them in terms of major new information. What they do give is a lot more detail both of the numbers and of what is going on behind the numbers. The key things I look for are:
- Earnings per share (EPS): to see more precisely how well the business is performing relative to expectations. In looking at EPS, it’s important to look at any adjustments that have been made. Sometimes companies will report an adjusted EPS as the headline number that is substantially higher than the basic EPS. Often this is because the company believes (or wants you to believe) that certain costs are one-off or exceptional and that the adjustment gives a better idea of underlying trading. But be careful as businesses obviously have a strong incentive to manipulate the numbers to show improved headline earnings. If there are adjustments I would always look into them to see if I am happy that these adjustments aren’t hiding anything. If unsure I would tend to be cautious and avoid buying.
- Cash flow and changes to net cash/debt: a more insidious way for businesses to hide costs from the headline earnings is to capitalise costs or to subtly shift its accounting practice to more aggressively record profits from customers that it wouldn’t have recognised yet previously. If earnings have risen but cash flow has fallen and/or net debt has risen, I would look for an explanation. There are lots of benign reasons for this, mostly around the need for the business to make investments to fund future growth but if I couldn’t find a decent explanation, again I would avoid.
- The narrative: many businesses are fairly complex with multiple products and geographies. I find that it’s generally worth skimming through the segmental reporting to get an idea of the narrative of the various different products or geographies. This can give a clearer picture of what is likely to drive future growth and what the risks are. This is useful context for better interpreting the companies’ outlook statement.
- The outlook statement. This is often the most important part of the results in my view. Outlook statements will pretty much always try to put a positive sheen on things so it’s important to calibrate your interpretation. Looking at previous statements can help – I treat a very positive outlook from a normally cautious management as a good buy signal. Outlook statements will often raise upcoming risks but downplay them or express optimism about the business’s ability to deal with them. I am very wary of this and will tend not to invest unless the statement is unequivocally positive and without any risks identified. A risk highlighted in an outlook statement can often be a precursor to a profit warning in my experience.
While it can be profitable to react quickly to a positive news statement, it can sometimes be a good idea to observe the immediate market reaction before deciding to buy a share. This is particularly the case if there is any uncertainty about how the statement relates to market expectations.
What I look for is a positive share price reaction and most importantly a big increase in the volume of shares being traded. This can indicate that institutions have started buying. If they have this can often continue for several days or weeks so it’s not always necessary to buy immediately after the market opens. There’s a balance between getting in quickly and waiting for this indicator of institutional buying to be confirmed – either way the liquidity advantage you have as a small private investor can let you build a position very quickly.