Here’s why Macquarie Group Ltd is urging you to buy downgraded stocks

Talk about foolish strategies! It seems that it is actually a good idea to buy stocks that have been sold off sharply on the back of a profit downgrade, according to Macquarie Group Ltd (ASX: MQG).

The broker had a hard look at the trading performance of companies that have seen a 5% or greater cut in their earnings per share (EPS) forecast by analysts in 2017.

While logic dictates that such stocks get cast into the sin bin for an extended period as they are shunned by investors, those who have bought into the stock right after a profit warning or downgrade have enjoyed around a 2% gain on average in under 30 days.

That may not sound like much to you, but if you annualise the gains, we are talking about a return of over 20%!

Broker EPS downgrade: Buy the dip!

Source: Macquarie Research, IBES

This phenomena could explain the trading performers of a number of notable sinners-to-winners, which includes QBE Insurance Group Ltd (ASX: QBE) following this week’s profit warning that never was from management, and Bendigo and Adelaide Bank Ltd (ASX: BEN) as it experienced a decent rally in the aftermath of its profit warning in October last year.

It is probably investors increased craving for risk that is driving this unusual behaviour where they are willing to roll the dice and buy a bargain bin castaway on the belief that things will turnaround for the company.

What this also means is that it’s a dangerous time to be a short-seller!

To be sure, this strategy has not worked in other periods. It seems 2017 was a really special year for equities, and given the persisting strong investor risk appetite, this trend might continue well into 2018.

On the other hand, the number of stocks that suffered a 5% or greater downgrade is lower than in previous years, and the smaller sample size may have affected the results.

However, the market hasn’t abandoned all logic and rationality. Macquarie noted that stocks that have enjoyed a broker recommendation upgrade have performed even more strongly, especially if this is accompanied by an EPS upgrade as well.

Some stocks that have recently enjoyed a consensus recommendation and EPS growth upgrade include mining giant Rio Tinto Limited (ASX: RIO), gaming machine maker Aristocrat Leisure Limited (ASX: ALL), energy company Oil Search Limited (ASX: OSH) and dairy products company A2 Milk Company Ltd (ASX: A2M).

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Motley Fool contributor Brendon Lau owns shares of Rio Tinto Ltd. The Motley Fool Australia owns shares of A2 Milk. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

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