“The first step in crafting the life you want is to get rid of everything you don’t.” – Joshua Becker

If we want to beat the market, we have to own stocks that are outperforming the market.  There are hundreds of indicators available to help pick stocks. But in my experience, the more complicated a strategy is, the less likely it will work in the future.

This year has been a good year for U.S. markets. Still, many individual stocks have not performed well and remain in downtrends, well below their peaks from the previous bull run. It’s been a stock picker’s market to say the least.  

And until the current investment environment for equities becomes more favorable (with bond yields retreating for starters), it will likely remain that way. The question is – how do we go about narrowing down our list to stocks with the best profit potential?

Let’s examine a three-step process that can guide us in this endeavor.

The Zacks Industry Rank

Here at Zacks we give you the tools to help identify leading stocks and outperform the market. Our Zacks Industry Rank identifies the top industry groups that contain market leaders, providing a tailwind to our investing success. This allows investors to jump on board before an emerging rally gets underway.

We can start by detecting leading industry groups. The Zacks Industry Group Rank makes this process easy for investors, classifying industries based on the earnings estimate revisions of the underlying stocks within each industry. If the stocks within a given group are experiencing positive earnings revisions, that industry will receive a higher ranking. Let’s take a look at an example.

The Zacks Retail – Home Furnishings industry is ranked in the top 39% out of approximately 250 industries. Because it is ranked in the top half of all Zacks Ranked Industries, we expect this group to outperform over the next 3 to 6 months. Digging a bit deeper, this industry has outperformed the market this year with a 15.6% return.

Quantitative research studies suggest about half of a stock’s future price appreciation is due to its industry grouping. By targeting stocks contained within leading industry groups, we can dramatically improve our odds of success. Also note the favorable valuation characteristics for this group below:

Image Source: Zacks Investment Research

Rising Earnings Estimates

Positive earnings estimate revisions are at the heart of the Zacks Rank. Our research shows that rising earnings estimates are the most powerful force impacting stock prices. Only the top 20% of all stocks that are experiencing the most substantial revisions are ranked as either a Zacks Rank #1 (Strong Buy) or Zacks Rank #2 (Buy). Let’s build on our example.

Within the Zacks Retail – Home Furnishings industry, Williams-Sonoma (WSM Quick QuoteWSM - Free Report) is a Zacks Rank #2 (Buy) stock. Williams-Sonoma is a specialty retailer of various goods for the home, offering cooking, dining, and entertainment products. Readers are likely familiar with the brand along with its others including Pottery Barn, West Elm, and Mark and Graham.

The retailer has witnessed a steady batch of positive earnings estimate revisions as of late. For the fiscal fourth quarter, analysts have increased their EPS estimates by 1.85% in the past 60 days. Williams-Sonoma has exceeded the earnings mark in each of the last four quarters, with an average surprise of 3.2%. These are the types of trends we want to look for when narrowing down our list of stocks to include in our portfolio.

Image Source: Zacks Investment Research

Relative Strength

One of the most useful measures to help investors identify leading stocks and funds in any market environment is relative strength. This technical analysis tool assists us in gauging how an investment has performed relative to the market or another relevant benchmark. For example, we could use relative strength to detect stocks that have outperformed the S&P 500.

Critics of relative strength as an indicator typically associate it with momentum investing, but I don’t view it that way. The market ultimately decides which stocks are best positioned for the present and future periods, and this tool helps us recognize those stocks.

We can see below that WSM has displayed relative outperformance versus the S&P 500 over the past several months:

Image Source: StockCharts

Simply put, in order to outperform the market, we need to be invested in stocks that are outperforming.

Final Thoughts

By focusing on stocks that are within leading industry groups, experiencing positive earnings estimate revisions, and that are showing relative strength, we can narrow down our list of stocks to those with the best profit potential.

Earnings season is underway and is beginning to heat up, with some major reports due out this week. Make sure you’re taking advantage of all that Zacks has to offer to uncover leading stocks like WSM.