Have you ever made an investment into a solid, good company, only to have the share price remain static for a number of years? Or have you seen a company announce a record profit, only to then watch the shares fall? Julia Lee explains the factors that make share prices move.
Let’s start with a story…
Let’s say that you buy a business for $1 million. It’s a corner store that has been growing at 10% a year over the last 10 years and you think that it will continue to grow at 10% each year going forward. Three months into the investment, you change your mind and would like to sell the business. Assuming that nothing has changed in those three months, how much are you likely to sell the business for?
The answer is probably around $1 million.
The point is that if nothing changes, the value of the business does not change.
It’s the same in the share market, if nothing changes the value of the business should not change and hence the share price also should not change.
When investing it’s important to ask: “What is the catalyst that will move the share price?” Is it a new product, a new strategy, new management or changing investor sentiment? All of these can be triggers for positive earnings momentum.
What is momentum?
Momentum describes something that is moving rapidly. Positive momentum describes accelerating movement. When referring to momentum in the market, it is usually a reference to either price or earnings momentum. Positive price momentum is where the price is moving upwards. Positive earnings momentum is where earnings are increasing.
Academic studies that support earnings momentum
Foster, Olsen and Shevlin (1984) show that there’s an annualised return of 25% from momentum strategies based on data from 1974-1981.
In addition, high earnings outperform low earnings according to Ball and Brown (1968) with the better performance lasting around 9 months after an earnings announcement.
Myers (2006), found that companies with increases in earnings per share (EPS) enjoy abnormal returns that average over 20% per year during first 5 years of consecutive increases.
Jegadeesh and Lakonishok (1996) noted that strong momentum signals are most prevalent when there is both positive earnings and positive price momentum.
There’s also empirical evidence to support the concept of price momentum, with Jegadeesh and Titman (1993) finding that stock with higher past returns tend to continue to have higher returns over a 3 to 12 month period.
To conclude, something needs to change to spur on prices to move. That something could be a new product, new strategy, new management or improved investor sentiment. The perception that this will lead to positive earnings momentum, leads to positive price momentum. Hence when investing, look for the catalyst which will drive higher earnings and higher share prices.
Julia Lee is an Equities Analyst with Bell Direct. You can catch Julia hosting the Tuesday shares session of Your Money, Your Call on the SKY Business Channel every Tuesday from 8-9pm where she takes live calls from traders and investors. She is also a contributor to industry publications and is a regular speaker at the Trading & Investing Seminars & Expo. Follow Julia on Facebook or Twitter.