Read more into read-across

A common practice for analysts is to look at competitors of companies they follow and infer from the results of these competitors what might happen to the companies under their coverage. This kind of read-across can be highly informative, especially when the source of it is a major player in the industry.

Of course, this read-across is also why share prices of companies in the same industry of a company reporting results tend to move in the same direction as the share price of the company that reports on the day.

But if you read this study from the University of Miami, you may come to the conclusion that share prices do not react strongly enough to such events. What this study did was to look at the earnings surprises of star firms in 55 industries in the US and the share price reaction of nonstar firms in the months after. The authors defined star firms as the four largest companies by market cap in each industry.

To no surprise, a positive earnings surprise in a star firm was on average followed by positive earnings surprises by nonstar firms reporting at a later date. Similarly, there is positive autocorrelation between star firms and nonstar firms in the same industry that lasts for several months.

And the last point is where it gets interesting. The authors of the study were able to create a long-short portfolio based on earnings surprises of star firms one to three months in the past and that long-short portfolio was able to outperform the market by 7% p.a. I don’t know how much of this outperformance would be destroyed by transaction costs, but what I do know is that based on the results of this research, investors can create a simple rule of thumb on how to exploit this effect.

The important result, in my view, is that nonstar companies with negative earnings surprises in the past tend to react much less to positive earnings surprises by star firms and vice versa. So, if a star company in an industry reports surprisingly positive results, go look for other companies in the same industry that not only disappointed with their last earnings results but also have a share price that significantly lags the share price of the entire industry over the last year. These are the companies where investors are quite pessimistic about the outlook and any kind of positive news takes much longer to filter through to the share price. And thus, these are the companies to buy in expectation of a positive earnings surprise on the next results day.

Similarly, if a star company in an industry has disappointing results and you are sitting on an investment in a nonstar company that has surprised positively in recent results and saw its share price rise more than the industry overall, the risk of a material setback in the share price at the next earnings announcement is higher than normal.