As the third-quarter earnings season unfolds, what could be a better time to talk about earnings surprises? After all, a positive earnings surprise or a beat matters the most, irrespective of earnings growth.
Why Is a Positive Earnings Surprise So Important?
Historically, stocks of companies with solid quarterly earnings (on a nominal basis) tank if they miss or merely meet market expectations. After all, a 20% earnings rise (though apparently looks good) doesn’t tell you if it has been decelerating.
Seasonal fluctuations also come into play. If a company’s Q1 is seasonally weak and Q4 is strong, it is likely to report a sequential earnings decline. In such cases, growth rates are misleading while judging the true health of a company.
It’s only after significant research and analysis on a company’s financials and initiatives that Wall Street analysts project its earnings. They also take a company’s guidance into consideration when deriving an earnings estimate.
Thus, outperforming that estimate is almost equivalent to beating the company’s own expectation as well as the market perception. If the margin of earnings surprise is big, it typically drives the stock higher right after the release. Thus, more than anything else, an earnings surprise can push a stock higher.
How to Pick Likely Achievers?
Investors tend to look for stocks that have the potential to beat on the bottom line but might not always succeed. One way of identifying the winners beforehand is by looking at the earnings surprise history of a company.
An impressive track record in this regard generally acts as a driver. It indicates the company’s ability to exceed estimates. Investors generally believe that the company will have the same trick up its sleeve to deliver yet another earning beat in its upcoming release.
The Winning Strategy
In order to shortlist stocks that are likely to come up with an earnings surprise, we chose the following as our primary screening parameters.
Last EPS Surprise greater than or equal to 10%: Stocks delivering positive surprise in the last quarter tend to surprise again.
Average EPS Surprise in the last four quarters greater than 20%: We lifted the bar for outperformance slight higher by setting the average earnings surprise for the last four quarters at 20%.
Average EPS Surprise in the last two quarters greater than 20%: This points to a more consistent surprise history and makes the case for another surprise even stronger.
In addition, we place a few other criteria that push up the chance of a positive surprise.
Zacks Rank less than or equal to 2: Only companies with a Zacks Rank #1 (Strong Buy) or 2 (Buy) rating can get through.
Earnings ESP greater than zero: A stock needs to have both a positive Earnings ESP and a Zacks Rank of #1, 2 or 3 for an earnings beat to happen, as per our proven model.
In order to zero in on those that have long-term growth potential and high trading liquidity we have added the following parameters too:
Next 3-5 Years Estimated EPS Growth (Per Year) greater than 10%: Solid expected earnings growth exhibits the stock’s long-term growth prospects.
Average 20-day Volume greater than 100,000: High trading volume implies that the stocks have adequate liquidity.
A handful of criteria has narrowed down the universe from over 7,700 stocks to 11.
Here are five out of 11 stocks that passed the screen:
Guess?, Inc. (GES - Free Report) : The company designs and markets one of the world's leading lifestyle collections of casual apparel, accessories and related consumer products. The stock belongs to a Zacks Industry Rank in the top 29%. It has a Zacks Rank #2.
Zumiez Inc. : The Zacks Rank #1 company is a leading specialty retailer of action sports related apparel, footwear, equipment and accessories. The Zacks Industry Rank is in the top 35%. You can see the complete list of today’s Zacks #1 Rank stocks here.
Yelp Inc. (YELP - Free Report) : This is a website engaged in providing information through the online community, offering social networking. Its Zacks Industry Rank is in the top 19%. Yelp carries a Zacks Rank #1.
Crocs Inc. (CROX - Free Report) : This is a rapidly growing designer, manufacturer and marketer of footwear under the CROCS brand. The stock sports a Zacks Rank #1. It belongs to a Zacks Industry Rank in the top 29%.
MasTec Inc. (MTZ - Free Report) : The company provides construction services to the telecommunications industry in the United States. The stock has a Zacks Rank #1 and the Zacks Industry Rank is in the top 37%.
You can get the rest of the stocks on this list by signing up now for your 2-week free trial to the Research Wizard and start using this screen in your own trading. Further, you can also create your own strategies and test them first before taking the investment plunge.
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Disclosure: Officers, directors and/or employees of Zacks Investment Research may own or have sold short securities and/or hold long and/or short positions in options that are mentioned in this material. An affiliated investment advisory firm may own or have sold short securities and/or hold long and/or short positions in options that are mentioned in this material.
Disclosure: Performance information for Zacks’ portfolios and strategies are available at: https://www.zacks.com/performance.
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