Front-Running the Elephants

Zacks

Can you name five boring industrial stocks that handed investors triple-digit gains in the past two years or less? If you guessed Caterpillar (NYSE:CAT - News), you'd have one of them. I included CAT the last time I wrote about 'earnings machines' right before Apple (NasdaqGS:AAPL - News) blew away the quarter last week.

That list of five companies with envious earnings momentum that returned doubles, triples, and five-baggers also included Netflix (NasdaqGS:NFLX - News), Chipotle (NYSE:CMG - News), and priceline.com (NasdaqGS:PCLN - News). Today, I give you four other industrial giants besides CAT, and I will add the Chinese web search dominator Baidu to round out the list.

The point of this exercise is to show you how a system that focuses on earnings momentum, as predicted by analyst estimate revisions, can keep you on the right side of powerful trends for long enough to realize those triple-digit gains.

Why You Should Still Buy the Dips in These Names

Here's more proof of the power of earnings estimate revisions, with four industrial stocks that are generally much sleepier -- and have value-oriented P/E's -- versus the technology and internet names...

Deere (DE): Since August 2009, $50 to $100

Eaton (ETN): Since September 2009, $25 to $55

Cummins (CMI): Since October 2009, $45 to $105

CNH Global (CNH): December 2009, $25 to $50

Baidu (BIDU): April 2010, $60 to $160

I include Baidu because I like doing these 'backtests' in groups of 5 -- and they just reported blow-out earnings again this quarter. Read my report 'Baidu's Persistent Search for Growth' for the details.

My 'backtest' criteria for entering a long position in the month shown for each name was this: when the stock first became a Zacks #2 Rank (buy) after having been a Rank #4 (sell) -- plus it had to have never looked back down again below a Rank #3 (hold).

As with the first group of five mentioned above, all these stocks experienced many weeks and months flipping between a Rank #1 (strong buy) and Rank #2. Here's how I explained it last week...

'What we have found is that very strong stocks tend to gravitate between Rank #1 and #2 for long periods over several months or quarters. Since the Zacks Rank focuses on analyst data only from the past 60 days, it highlights recent estimate revisions and is intended to alert you to near-term momentum.

But even a stock that tends to hang out in the #1 and #2 Ranks will sometimes slip down to a #3 hold simply because old data has dropped off, no new estimates have come in, and earnings appear to have flat lined. But this is really just a temporary lull, more so in analyst activity than in the company's real earnings power.

The five stocks I mentioned with triple digit returns in the past 2 years or so since the recession -- AAPL, CMG, NFLX, PCLN, and CAT -- all spent significant periods as #1 or #2 Rank stocks, often flipping back and forth as analysts moved estimates and other stocks competed for a spot on the top 220.'

EM and EER

Why would you still put money into the four industrial stocks in my list even after the doubling most of them have experienced? Two reasons: Emerging Markets (:EM) and Earnings Estimate Revisions (:EER).

EM is the driving force of their profits as billions of citizens and their governments clamor for the lifestyles of the West. I have written extensively about the massive push toward urbanization in China, India, Brazil and dozens of other countries that is driving demand for the equipment and technology of these firms to build infrastructure. See my 'Industrial Strength Power' for the most recent view on some of these names.

EER are the core of the model we use at Zacks to define those stocks with the highest return potential based on earnings momentum. Here's how I explained the power of this system last week:

'The primary achievement of this focus on earnings estimate revisions (:EER) is that it precedes, and thus predicts, what institutional money managers -- the elephants of financial markets -- will do with their cash.

How? Because they have valuation models that tell them what they are willing to pay for a stock today based on its earnings tomorrow.

And what do they plug into their valuation models to give them that answer? Forward-looking earnings estimates that are produced by hundreds of quantitative minds in the investment community.

Valuation Models and the Price of Tomorrow's Profits

'Why? Because professional stock investors -- portfolio managers for pension funds, mutual funds, insurance companies, and hedge funds -- are forward-looking by nature. They don't care about the trailing P/E. They are focused on the forward P/E which only comes from analyst earnings estimates.

And if estimates of futures earnings are rising in both agreement and magnitude among the analysts, then the fair value price that the valuation models of institutional investors spits out will be rising. In other words, higher estimates today equal higher stock prices tomorrow.

Are the analysts always right? Hardly, but in aggregate, the Zacks Rank stock rating system is able to crunch and quantify their inputs every night into a single very valuable and historically predictive number through a proprietary formula that sorts a universe of 4,400 stocks into five ratings.

The system alerts you immediately to earnings momentum and this gives you time to buy (or sell) a stock ahead of the elephants who usually take several weeks, and layers of committee approvals, to accumulate new positions.'

Continuation of Institutional Support

The four industrial stocks above -- ETN, CMI, DE, and CNH -- are still either a Zacks #1 Rank (strong buy) or #2 (buy) based on their earnings momentum. And they all have something else in common: a forward P/E multiple very close to 13, which is about the market average.

But not all 500 stocks in the S&P index have this kind of earnings power. And that's why all four of these names will still be on the buy lists of fund managers, because a forward P/E of 13 times looks cheap when the momentum is still up. Think of the pauses that you see in buying as 'continuation patterns' on a price chart.

The institutions sometimes take a break from buying, especially if stock slips back to a #3 Rank because there's just not enough new analyst data. But as soon as the new estimates roll in, the patterns of earnings momentum and price appreciation tend to continue.

Long-Term or Short, Bet Aggressively on EER

In a two year period of earnings momentum like these ten stocks have experienced, how do you know to stay with them when they drop occasionally to a #3 Rank? How do you know the rapid recovery isn't over and they are headed to a Rank #4 next as the earnings estimate revisions begin to turn downward?

Investors who believed in these stocks for the slightly longer run than one or two quarters' earnings events could have easily hung on with a rule that asked 'Why sell a strong earnings machine if the story and trend seem bound to continue?' After all, a body in motion...

In this way, you are thinking long-term, yet being aggressive with stocks that are experiencing both rapid earnings momentum and institutional support. Now, the reality is that very few investors buy these stocks and reap a full triple-digit gain. Most get in too late, or out too early.

But even capturing a 25-50% move in a quarter or two will do amazing things for your long-term portfolio results. And this is simple enough to do when you put the low-risk, high-reward dynamics of EER on your side.

Kevin Cook is a Senior Stock Strategist for Zacks.com

BAIDU INC (BIDU): Free Stock Analysis Report

CATERPILLAR INC (CAT): Free Stock Analysis Report

CUMMINS INC (CMI): Free Stock Analysis Report

DEERE & CO (DE): Free Stock Analysis Report

EATON CORP (ETN): Free Stock Analysis Report

CNH GLOBAL NV (CNH): Free Stock Analysis Report

Zacks Investment Research



More From Zacks.com

Rates

View Comments (0)