Hunting for stocks with estimate-beating potential ahead of an earnings season is a common practice among investors. This is because investors always try to gauge how a stock will perform in the future and invest in the ones that appear promising.
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.
Also, seasonal fluctuations can 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.
On the other hand, after a whole lot of research and analysis on a company’s financials and initiatives, 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. 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 Locate Potential Outperformers?
Now, finding stocks that have the potential to beat on the bottom line is a dream that investors chase but might not always come true. One way of fulfilling it is by looking at the earnings surprise history of a company.
An impressive track in this regard generally acts as a driver in sending a stock higher. It indicates the company’s ability to exceed estimates. And 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 followingas 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 have narrowed down the universe from more than 7,700 stocks to five.
Here are all five stocks:
Vertex Pharmaceuticals Incorporated VRTX: The company, which is into the development of small molecule drugs targeting serious diseases, mainly targets cystic fibrosis (CF). It belongs to a favorable Zacks industry (placed at the top 38% of 250+ industries).The stock carries a Zacks Rank #2. You can see . the complete list of today’s Zacks #1 Rank stocks here HealthEquity Inc. HQY: It provides integrated solutions for health-care account management, health reimbursement arrangement and flexible spending accounts for health plans, insurance companies and third-party administrators in the United States. It has a Zacks Rank #2. The stock comes from a favorable Zacks industry (top 43%). Mitek Systems Inc. MITK: The Zacks Rank #1 company is engaged in the development and sale of software products that focus on intelligent character recognition and form processing technology, products and services for the document imaging markets. It hails from a favorable Zacks industry (top 1%). Fortinet Inc. FTNT: The provider of network security appliances has a Zacks Rank #2. EVO Payments Inc. ( EVOP Quick Quote EVOP - Free Report) : This Zacks Rank #2 company is a payments service provider of merchant acquiring and processing solutions for merchants, independent software vendors, financial institutions, independent sales organizations, government organizations and multinational corporations. It belongs to a favorable Zacks industry (top 37%).
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Disclosure: Performance information for Zacks’ portfolios and strategies are available at: . http://www.zacks.com/performance