Some of the largest gains on my share recommendations have been made by companies in earnings upgrade cycles. That’s because the share price not only gets a boost from the higher level of earnings reported, but investors are likely to value the operation on higher earnings’ multiple once they have confidence in management’s ability to continue to outperform guidance. The twin effect creates a strong share price tailwind.
Companies in upgrade cycles have many characteristics, the most obvious being that almost without fail the industry backdrop is favourable. For instance, restocking and reinvestment cycles after a sector has gone through a lean period are important as this can produce a tailwind for sales, and profits.
Operational leverage is important too, and it pays to seek out companies whose profits accelerate more quickly than sales, so an increasing amount of incremental revenue drops down to the bottom line in a positive trading environment. Impressive cash generators are ideal candidates because a company that converts a high percentage of profit to operating cash flow can reinvest it back in the business to boost shareholder returns while at the same time rewarding investors with a progressive dividend policy. Several of the companies I outline below are displaying all these characteristics.