What is a Real Earnings Surprise?

In this article we are going to tackle this little understood issue. Better yet, I will share with you two ways to profit from earnings surprises. More on that later.

3 Reasons Stocks Can Drop After an Earnings Surprise

1) Estimates vs. Expectations: The standard definition of an earnings surprise is when actual earnings come in higher than earnings estimates. But those estimates are the "published" numbers from the brokerage analysts. Quite often investors tend to develop their own unique set of expectations that can differ greatly from the Wall Street analysts. If there is too much optimism ahead of the release, then actual earnings will need to be a blowout in order to appease the inflated expectations of investors. This is the most common reason why some stocks fall after a "supposed" earnings beat.

2) Quality of Earnings: The highest quality earnings come from having robust revenue growth. This means that the company's products or services are in high demand and should stay that way. However, these days far too much of the earnings being reported is generated from cost cutting and other "accounting gimmickry". The problem is that the benefits of these moves don't last. When the market gets a whiff that the earnings are unsustainable, no matter how strong the beat, shares will most likely drop.

3) Forward Guidance: Plain and simple, when you buy a stock you are taking an ownership stake. And what owners of companies care about is the stream of future earnings. So if a company beats earnings for the quarter just reported, but warns that future quarters will see lower earnings, then that stock will go down...and go down fast.

2 Ways to Make Money on Earnings Surprises

So now that we have outlined things that can go wrong after earnings surprises, let's shift gears and talk about something even more important; how to turn a profit from earnings surprises. Here are two ways to go about it.

Good Way: Buy shares in any company that had an earnings surprise and rose the day following the news. These stocks experience what academics call the "Post Earnings Announcement Drift," Studies clearly show that these stocks usually outperform the market over the next 9 months. Conversely, you should sell any stock in your portfolio that misses its earnings numbers as it likely to underperform the market for the next few quarters. The downside of this approach is that there are literally thousands of stocks to choose from every quarter.

Best Way: Find stocks where the earnings "whispers" tip you off that a big surprise is coming. Buy the shares shortly before the announcement and enjoy quick gains of 10%, 15%, 20% when the earnings surprise is officially reported.

I know what you're thinking. There are no Magic 8-balls for the stock market, so how is this possible??? But fret not; this isn't a magic show. It's pure science.

The concept of finding a profitable source of earnings whispers has long been the Holy Grail of stock investing. Many experts have tried and failed to make this work. In fact, we have been researching this for 3 straight years.

Early on we found clues that told us stocks more likely to surprise, but not necessarily rise in price. Not til this past Summer did we discover the right combination of elements that predicted surprises 77.96% of the time. Better yet, we backtested this strategy over the last ten years and it produced an astounding +62.1% average annual return. (I probably don't need to remind you, but over the last 10 years the S&P delivered negative returns for investors).