Why a positive earnings surprise in a top firm means you should invest in smaller underperformers in the same sector

Share prices of companies in the same industry often mirror each other when one reports earnings. This makes sense, says Liberum strategist and blogger Joachim Klement, but market reactions often don’t go far enough.

Klement notes a recent study which examines earnings surprises of top firms in 55 US industries and their impact on lesser-known companies in subsequent months. Unsurprisingly, positive earnings surprises from top firms tended to be followed by positive surprises from their counterparts, but markets were slow to price this in. The authors note a long-short portfolio based on earnings surprises of star companies would have outperformed by 8.6 per cent annually.

Some of this outperformance would obviously be erased by transaction costs, but Klement says active investors can create a simple rule of thumb to exploit this effect. If a big company stuns with positive results, seek out underperforming firms in the same industry that disappointed with their last earnings report. Markets tend to be pessimistic in such cases, and these overlooked opportunities can yield handsome gains when the next earnings report arrives.

[ European shares slide to 14-week low amid fresh hike fears ]

Conversely, when a big company disappoints, be cautious if you hold shares in a non-star company that has been outperforming – the risk of a setback at the next earnings announcement may be higher than you think.