The 'Double Up' screen keeps taking advantage of inefficient markets

Imagine you’ve just returned from a month-long holiday, on which you avoided all updates relating to your stock portfolio.

Now home and slowly catching up on what you’ve missed, you see that one of your holdings, Nike (US:NKE), used its fourth-quarter results on 27 June to warn that issues in China would likely persist, and downgrade its outlook for the full financial year. Almost four weeks after the fact, you feel forced to ask yourself: what does this mean for future earnings growth and stock returns?

According to a fascinating recent study, which posed a variation of this hypothetical scenario to more than 11,000 investors and academics, your answer likely depends on whether or not you are an economist. From an academic, theoretical perspective, the news should be irrelevant. It is old, and therefore ‘priced in’ by an efficient market that long ago assimilated the information.

A glance at Nike’s price chart would appear to confirm this. Within a day of issuing its update, Nike shares had dropped 20 per cent.

However, according to the paper, this isn’t how investors interpret seemingly ‘stale’ information. While 76 per cent of academic experts responded that four-week-old bad news should have zero impact on future stock returns, between 45 and 81 per cent of investors thought it would have a negative effect.

This is an important lesson for investors as a whole – particularly those looking to trade on price momentum.

Even if the academics are correct in their faith in efficiency, what ultimately matters to prices is the behaviour of market actors. So, while a market may look inefficient (or suffer from what the paper’s authors term an “equilibrium neglect”), they are in fact responding to a different logic. In the case of Nike, a negative update isn’t viewed as an isolated event, but a harbinger of worse to come.

Those authors – Peter Andre, Philipp Schirmer, and Johannes Wohlfart – aren’t the only ones to have spotted markets’ very gradual pricing of new information. Last October, we debuted a new stock screen to try to exploit this very tendency.

The Double Up screen (as I’ve called it) is loosely based on a 2023 paper by two German academics, who found that underreaction to positive news was particularly prevalent when it involved stocks trading near their 52-week highs. The study’s findings suggest that rather than simply buy into positive earnings surprises, traders should look for shares where the anchoring effect of high prices may have held back earnings-positive developments, to better capture the ‘drift’ that follows.

The quarterly screen, which is applied to both the FTSE All-Share and Aim constituent lists, works off two data sources that appear weekly in our Ideas Farm section: stocks at or near their one-year highs, and stocks with the largest one-month bumps in broker earnings forecasts. By hunting for names that score highly on both measures, the Double Up restricts itself to a pair of rules:

• A share price within 5 per cent of the 52-week high.
• An upgrade in the next 12 months’ earnings per share forecast of at least 3 per cent, over the last month.

So far, it appears to be working. April’s cohort of 30 stocks posted a total return of 6.7 per cent in the period to 17 July, outperforming both the Aim and FTSE All-Share indices, and making it three out of three quarters in which the screen has beaten its benchmark. The bigger question going forward is whether three, six or 12 months is the best window to capture the ‘drift’ effect.

Given the limited datasets and non-continuous time series involved, I’m doubtful we can get a clear-cut answer to this question. But it’s interesting to compare all the same. And while all three ‘versions’ of the Double Up screen are ahead of the benchmark, last October’s original batch of nine stocks continue to lead, despite a middling performance from the oil majors.

This month, the screen has identified a 21-strong list of UK stocks that tick both the earnings-upgrade and 12-month high boxes. Aside from their size (all have market capitalisations below £5bn) and a slight sector bias (toward precious metals and asset managers) I’m not detecting any big trends. We’ll find out in three months’ time whether a market-beating summer run proves the common thread.