It is not surprising that before an earnings season, every investor looks for stocks that can beat market expectation. This is because investors always try to position themselves ahead of time and look to tap stocks that are high-quality in nature.
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 earnings growth has been exhibiting a decelerating trend.
Also, seasonal fluctuations come into play sometimes. If a company’s Q1 is seasonally weak and Q4 strong, then it is likely to report a sequential earnings decline. In such cases, growth rates are misleading while judging the true health of a company.
Meanwhile, after much brainstorming and analysis of companies’ financials and initiatives, Wall Street analysts project earnings of companies. They in fact club their insights and a company’s guidance 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. And 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 Find Stocks That Can Beat?
Now, finding stocks that have the potential to beat on the bottom line may be investors’ dream but not an easy job. One way to do this is to look at the earnings surprise history of the company.
An impressive track in this regard generally acts as a catalyst in sending a stock higher. It indicates the company’s ability to surpass estimates. And investors generally believe that the company will apply the same secret sauce to execute yet another earning beat in its next 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 raise 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, 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 13.
Here are five out of 13 stocks:
Columbia Sportswear Company (COLM - Free Report) : This company is into the designing, sourcing, marketing and distribution of active outdoor apparel and footwear, with operations in North America, Europe and Asia. It belongs to a top-ranked Zacks industry (top 18%). The stock carries a Zacks Rank #1. You can see the complete list of today’s Zacks #1 Rank stocks here.
Illumina Inc. (ILMN - Free Report) : The company is improving human health by unlocking the power of the genome. It has a Zacks Rank #1. The stock belongs to a top-ranked Zacks industry (top 35%).
WellCare Health Plans Inc. (WCG - Free Report) : The Zacks Rank #1 company focuses on providing government-sponsored managed care services, primarily through Medicaid, Medicare Advantage and Medicare Prescription Drug plans. It hails from a top-ranked Zacks industry (top 15%).
athenahealth Inc. (ATHN - Free Report) : This is a leading provider of Internet-based business services for physician practices. It hails from a top-ranked Zacks industry (top 46%). It has a Zacks Rank #1.
Caterpillar Inc. (CAT - Free Report) : This is a Zacks Rank #2 company is a manufacturer of construction and mining equipment, diesel and natural gas engines, industrial gas turbines and diesel-electric locomotives. The company belongs to a top-ranked Zacks sector (top 44%).
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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: http://www.zacks.com/performance.
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