As we close the books on the second quarter, stocks are pressing towards their highs once again. That is a tenuous place to be, given that Europe's problems are by no means solved. And because the slowing world economy may finally be hampering our growth in the US. That is why this earnings season is so important.
There will be big winners and losers depending on the strength of their individual reports. Yet that brings to mind one of the most confusing things about earnings season:
Why do some stocks sky rocket on a positive earnings surprise while others fall off a cliff?
In this article we are going to tackle this little understood issue. Better yet, I will share with you two ways to profit from earnings surprises. More on that later.
3 Reasons Stocks Can Drop After a Positive Earnings Surprise
1) Estimates vs. Expectations: The standard definition of an earnings surprise is when actual earnings comes in higher than earnings estimates. But those estimates are the published numbers from the brokerage analysts. Quite often investors tend to develop their own unique set of expectations that can differ greatly from the Wall Street analysts. If there is too much optimism ahead of the release, then actual earnings will need to be a blowout in order to appease investors' inflated expectations. This is the most common reason why some stocks fall after a supposed earnings beat.
2) Quality of Earnings: The highest quality earnings come from having robust revenue growth. This means that the company's products or services are in high demand and should stay that way into the future. However, these days far too much of the earnings being reported is generated from cost cutting and other accounting gimmickry. The problem with that is that the benefits of these moves don't last. When the market gets a whiff that the earnings are unsustainable, no matter how strong the beat, shares will most likely drop.
Ready to make quick buy/sell moves this earnings season? A Zacks research breakthrough can actually tip you off to positive earnings surprises BEFORE they're reported. Its degree of accuracy reaches 80% - a level that was previously unthinkable.
Even better, this accuracy has triggered the best 'surprise' stock recommendation win rate of any Zacks investment concept. High demand forced the closing of this strategy to new investors last April. It's open to you today, but the door must close again by Sunday, July 8.
3) Forward Guidance: Plain and simple, when you buy a stock you are taking an ownership stake. And what owners of companies care about is the stream of future earnings. So if a company beats earnings for the quarter just reported, but warns that future quarters will see lower earnings, then that stock will go down... and go down fast.
2 Ways to Make Money on Earnings Surprises
So now that we have outlined things that can go wrong after an earnings surprise, let's shift gears and talk about something even more important: How to turn a profit from earnings surprises. Here are two ways to go about it.
Good Way: Buy shares in any company that had an earnings surprise and rose the day following the news. These stocks experience what academics call the 'Post Earnings Announcement Drift'. Studies clearly show that these stocks usually outperform the market over the next 9 months. Conversely, you should sell any stock in your portfolio that misses its earnings numbers as it is likely to underperform the market for the next few quarters. The downside of this approach is that there are literally thousands of stocks to choose from every quarter.
Best Way: Find stocks where the earnings 'whispers' tip you off that a big surprise is coming. Buy the shares shortly before the announcement and enjoy quick gains of 10%, 15%, 20% when the earnings surprise is officially reported.
I know what you're thinking. There are no Magic 8-balls for the stock market, so how can this be possible??? But fret not; this isn't a magic show. It's pure science.
The concept of finding a profitable source of earnings whispers has long been the Holy Grail of stock investing. Many experts have tried and failed to make this work. In fact, we have been researching this for 3 straight years.
Early on we found clues that told us stocks more likely to surprise, but not necessarily rise in price. Not till the Summer of 2010 did we finally discover the right combination of elements that predicted POSITIVE surprises 77.96% of the time. This has led to the highest overall stock-picking 'win' rate for any Zacks strategy.
Where to Find These Stocks
We can't share all the details of the formula with you, but the new system relies on two under-used criteria coming from the brokerage analyst community. These two factors are then layered on top of other time-tested elements such as the Zacks Rank and Zacks Industry Rank to find only the best stocks in the best industries.
If you would like to get in on strong potential profits every earnings season, and are ready to jump quickly on the flurry of positive surprises this strategy turns up, then I invite you to join us. But don't delay. We can't let too many share these recommendations, and must close the door to new investors this Sunday, July 8.
Wishing you great financial success,
Steve Reitmeister has been with Zacks since 1999 and currently serves as the Executive Vice President in charge of Zacks.com and all of its leading products for individual investors. After many long years of research by our team, he is extremely proud to share their historic earnings prediction breakthrough, the Zacks Whisper Trader.
More From Zacks.com