According to Zacks - What is a Real Earnings Surprise?

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Apr 01, 2011, 10:06 ET

CHICAGO, April 1, 2011 /PRNewswire/ -- As we close the books on the first quarter, stocks are pressing their highs once again. That is why this earnings season is so important.

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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 skyrocket on a positive earnings surprise while others fall off a cliff?

This article explores that little understood issue. Better yet, it shares two ways to profit from earnings surprises. More on that later.

3 Reasons Stocks Can Drop After an Earnings Surprise

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.
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. 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.
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.

Maybe you're thinking, "There are no Magic 8-balls for the stock market, so how can this 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, Zacks Investment Research has been studying this for 3 straight years.

Early , we found clues that predicted stocks more likely to surprise, but not necessarily to rise in price. Not til this past Summer did we discover the right combination of elements that predicted surprises 77.96% of the time. Better yet, we backtested this strategy over the last ten years and it produced an astounding +62.1% average annual return. (You probably don't need to be reminded that, over the last 10 years, the S&P delivered negative returns for investors).

Where to Find These Stocks

We can't share all the details of the secret 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 receive these profitable stock picks every earnings season, then you are welcome to look into the Zacks Whisper Trader. Don't delay. We are only making it available to new investors temporarily. And given the tremendous response to date, the remaining spots won't last for long.

Learn more about the Zacks Whisper Trader

About Zacks Investment Research

Zacks.com is a property of Zacks Investment Research, Inc., which was formed in 1978 by Len Zacks. The company continually processes stock reports issued by 3,000 analysts from 150 brokerage firms. It monitors more than 200,000 earnings estimates, looking for changes.

Then, when changes are discovered, they're applied to help assign more than 4,400 stocks into five Zacks Rank categories: #1 Strong Buy, #2 Buy, #3 Hold, #4 Sell, and #5 Strong Sell. This proprietary stock-picking system continues to outperform the market by a nearly 3-to-1 margin.

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Zacks Investment Research is under common control with affiliated entities (including a broker-dealer and an investment adviser), which may engage in transactions involving the foregoing securities for the clients of such affiliates.

Disclaimer: Past performance does not guarantee future results. Investors should always research companies and securities before making any investments. Nothing herein should be construed as an offer or solicitation to buy or sell any security.

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SOURCE Zacks Investment Research, Inc.