A simple way to add more 'alpha' to your portfolio

When a company publishes results or trading updates that beat market expectations, investors tend to like it. Normally, this leads to higher demand for its stock, pushing its price higher.

Advocates of the efficient market hypothesis tend to see investors’ snap reaction to strong news or results as a single repricing event. This theory holds that once an update is out in the world, it is quickly assimilated alongside all the other information that is relevant to finding a fair value. Factor in these new data points, tweak your expectations and – hey presto – a new price can be set.

In reality, the digestion process can be much slower. For one, even though trading algorithms now act as lightspeed interpreters of new information, the detail behind an apparently bullish update might not be immediately apparent. Some companies’ financial results can be esoteric, run to hundreds of pages, or omit details that are only later clarified in earnings calls or presentations.

A company that beats expectations might then find its shares rising for days, weeks or months as analysts make their earnings upgrades, and investors navigate any liquidity issues that prevent them from buying the volumes they desire. This all goes on, despite an absence of ‘new’ information.

Sometimes, there are technical reasons for a market’s slow metabolism. While most of Marks & Spencer’s (MKS) 128 per cent share price jump over the past year is down to better company trading and rising investor expectations of future profits, some of the rally is due to the stock’s promotion to the FTSE 100, and appearance on the radar of funds that are obliged to buy in. Indirectly, this still amounts to the market’s delayed processing of good news.

Put differently, markets aren’t as efficient as we think. The slow digestion of news, and the steady share price drift that leads to, might also explain why momentum strategies can work, and why traders talk a lot about befriending trends.

Now, we have evidence of when this positive drift might be at its most powerful. Earlier this year, two academics from the Technical University of Munich – Tobias Kalsbach and Steffen Windmüller – published a paper that sought to explain slow digestion with reference to a psychological phenomenon known as the anchoring effect.

The anchoring effect, first documented by the behavioural economists Amos Tversky and Daniel Kahneman in the 1970s, relates to the way an individual’s choices or views are influenced by a reference point or "anchor" that may be irrelevant. As a proxy for a market anchor, Kalsbach and Windmüller looked at 52-week price highs, and how this affected investors’ digestion of news.

Across 23 developed markets between 2004 and 2021, the pair found that when stocks traded near their yearly highs, investors were more reluctant to buy in on the back of market-beating updates. Similarly, investors were reluctant to digest negative news when stocks were near their yearly lows.

Either way, it seems that a stock’s proximity to its recent apexes may delay a process that would otherwise push a share price through the psychological anchor. The inference is that investors shouldn’t just look to buy stocks posting positive earnings surprises, but stocks that have posted positive earnings surprises and trade near their 52-week highs. Indeed, the paper found that by factoring this into a trading strategy, investors might add 6.8 percentage points of alpha per year.

Readers can expect a stock screen on this theme in the coming months. But if you can’t wait until then, look no further than our Ideas Farm data below.

Thanks to Liberum strategist Joachim Klement for highlighting the study.