Does good news make a company a good investment?

A global sportswear brand signs a deal with a new supplier that is meant to cut its raw material costs by a fifth. Industry experts call it 'an unexpected success', and stock market traders take notice. Four weeks later, you have money to invest. Would you expect the company's shares to do better over the next year than if it had simply kept its old supplier?

If you said yes, you're in good company. Economists from the universities of Bonn, Cologne and Frankfurt put exactly that question to a group of British adults earlier this year and published the results in a July paper. 82% expected the shares to do better. About three in four private investors surveyed in the US and Germany said the same, and so did 58% of fund managers at two large German fund groups. In those surveys, people who answered three standard financial literacy questions correctly were more likely to expect the shares to do better.

The finance academics the same team surveyed mostly disagreed. Two thirds of them said the news would make no difference to returns.

Start your trial of MoneyWeek today

Get unparalleled financial insight, analysis and expert opinion you can profit from.

Start your trial

Sign up for MoneyWeek’s free twice-daily newsletter.

Join more than 165,000 subscribers and keep yourself informed with latest financial news, insights and expert analysis to help you understand what really matters when it comes to your finances.

Join more than 165,000 subscribers and keep yourself informed with latest financial news, insights and expert analysis to help you understand what really matters when it comes to your finances.

Sign up

For a big, closely watched company like the one in the survey, the academics are right. The reason is the price.

Why does good news look like a good buy?

The problem is where people look. When the British group explained their answers, almost all talked about the company's prospects. Only 7% mentioned the share price. In effect, the researchers argue, people answer the question 'Is this a good company?' when they have been asked 'Is this a good investment?'

Those are different questions, and the difference is the price.

“What they don't think about is how much these shares cost to buy, which will also have gone up,” says Philipp Schirmer of the University of Bonn, one of the paper’s authors, describing private investors.

In the four weeks since the announcement, other investors have read the same news and bid the shares up. The same amount of money now buys a smaller slice of the company's bigger profits.

What happens when you count the shares?

So the researchers tried showing people the price. It made only a modest difference. A second British group read the same scenario with one addition: the shares had risen 14% since the announcement. Still, 70% expected them to do better, down from 82%. Many took the higher price as a sign of a better company.

What worked was spelling out what the price meant. A third group saw the same prices, plus the trade they implied: $1,000 bought 16 shares if the company had kept its old supplier, but only 14 after the good news. This time 49% expected the shares to do better, the lowest figure the researchers recorded among members of the public.

Some people in that group swung too far the other way and expected the shares to do worse. Counting the shares is a way to weigh good news against its price, not a reason to sell.

You can do the same count yourself whenever good news tempts you to buy. Say you have £1,100 to invest, and the shares were 400p before the announcement. Your money would have bought 275 shares. At 440p today, it buys 250. Those 25 missing shares are the price of the good news. A rough rule of thumb shows what that price assumes. If investors still value the shares on the same price/earnings (P/E) ratio, a 10% rise in the price means they now expect profits to be about 10% higher, for good.

So before buying, ask whether the news is worth more than that, and whether you know anything the market doesn't.

Doesn't good news keep paying for a while?

The best argument for buying anyway is that markets are slow to digest news. For decades, researchers found that shares kept drifting in the direction of an earnings surprise for weeks afterwards. If that held today, four-week-old news would have more to give.

In big British companies, it largely doesn't. A 2024 study of FTSE 350 companies from 2000 to 2021 found that the drift after good earnings news was small and quick. In the ten trading days after the announcement, shares with good news beat the market by 0.68% on average. After 60 days, the figure was 0.71%. Almost all of the extra return arrived in the first fortnight, so someone buying after four weeks missed it.

Even someone who bought straight away would have kept little of it. Those extra returns were measured before costs, and stamp duty alone takes 0.5% of what you invest in most UK shares.

All of this is about big companies. The UK evidence is thinner for smaller stocks, including those on AIM. A 2022 study of US shares by Charles Martineau found that the drift had gone from all but the very smallest companies by 2006, but lasted longer among those. For a big, closely watched company like the one in the survey, almost all of the news is in the price within a fortnight.

So is a good company a good share?

Terry Smith's Fundsmith sums up its approach in three steps: buy good companies, don't overpay, do nothing. Most of the people in the survey stopped after the first.

A good company can be a good share, but not because of news that everyone has already read.

The people who owned the shares when the deal was announced have had the rise. Four weeks later, the price you pay includes it.

So when a share is tipped on the back of good news, count what your money buys now against before the news broke. If the tip gives no reason beyond the news itself, the good news belongs to someone else.