Zacks Investment Research
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.
Seasonal fluctuations also 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.
It’s only after significant research and analysis on a company’s financials and initiatives that 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. 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?
Investors tend to look for stocks that have the potential to beat on the bottom line but might not always succeed. One way of identifying the winners beforehand is by looking at the earnings surprise history of a company.
An impressive track record in this regard generally acts as a driver. It indicates the company’s ability to exceed estimates. 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 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 slightly higher by setting the average EPS 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 surprise.
Zacks Rank less than or equal to 2: Only companies with a Zacks Rank of #1 (Strong Buy) or 2 (Buy) can get through.
Earnings ESPgreater than zero: A stock needs to have both a positive Earnings ESP and a Zacks Rank of #1, 2 or 3 (Hold) 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 narrowed down the universe from over 7,700 stocks to just seven.
Here are five out of the seven stocks:
IAC/InterActiveCorp (IAC - Free Report) ): This is a leading media and Internet company. The stock carries a Zacks Rank #2. You can see the complete list of today’s Zacks #1 Rank stocks here.
Tactile Systems Technology Inc. (TCMD - Free Report) ): This is a medical technology company, which develops medical devices for the treatment of chronic diseases at home. It has a Zacks Rank #2 and belongs to a top-ranked Zacks industry (top 41%).
Martin Marietta Materials Inc. (MLM - Free Report) : The Zacks Rank #2 company is engaged principally in the building materials business, including aggregates, cement, ready mixed concrete, and asphalt and paving product lines. It hails from a top-ranked Zacks industry (top 36%).
Fortinet Inc. (FTNT - Free Report) : This Zacks Rank #2 company is a provider of network security appliances and Unified Threat Management network security solutions to enterprises, service providers and government entities worldwide. The company belongs to a top-ranked Zacks industry (top 17%).
Intuit Inc. (INTU - Free Report) : The Zacks Rank #2 company provides financial management, and compliance products and services for small businesses, consumers, self-employed and accounting professionals. It hails from a top-ranked Zacks Industry (top 26%).
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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: https://www.zacks.com/performance.