At the end of every year, major publications like the Wall Street Journal produce a list of stocks with the biggest gains. What do these stocks have in common? Almost without fail these companies experienced a surge in earnings that greatly surpassed expectations - and the stock subsequently soared. Another term for this surge is positive earnings momentum.
On the flip side, stocks that fell the most during the year experienced negative earnings momentum. To sum it up:
- Good earnings beget more good earnings beget higher share prices
- Bad earnings beget more bad earnings beget lower share prices
As investors, our goal is to line up our portfolios with as many stocks experiencing positive earnings momentum as possible. How do we do that? First we must understand the dynamics of earnings momentum.
Dynamics of Earnings Momentum
Publicly-traded companies are large organisms that include many employees, products, buildings, equipment, etc. When they are experiencing positive earnings momentum, it means that most everything is going right; i.e. a great management team, first rate products and services, happy employees and delighted customers. These aspects have a self-reinforcing quality that will keep the company headed in the right direction for an extended period of time. The result being a string of earnings reports well above expectations and a booming stock price.
However, the company experiencing negative earnings momentum will behave in the opposite way; a poor management team, inferior products and services, disgruntled employees and dissatisfied customers fleeing to the competition. As you know, this is very bad for corporate profits and thus the stock price.
I like to think of a company as a large freight train stretching as far as the eye can see. When things are going well the train just keep rolling down the track. There is a positive rattle and hum to that train that everyone enjoys.
Now imagine the conductor notices that the train is going in the wrong direction. The train is headed south when it needs to go north. Now ask yourself how much time and energy does it take to stop that train? Even worse, how long will it take to back the train up to a spot where it can turn around?
The same is true for a large company that's headed in the wrong direction. Do you think it can be turned around in one quarter? Or two? History shows that not to be the case. Yet too many of us are content to hold onto stocks that have earnings disappointments only to see share prices continue to plummet. I cannot say this emphatically enough:
Sell all companies with negative earnings surprises - immediately!
How to Find Companies with Positive Earnings Momentum?
It’s actually quite easy. Len Zacks, the founder of my firm Zacks Investment Research, scientifically proved over 30 years ago that companies receiving increased earnings estimates from brokerage research analysts will more likely beat earnings expectations in the future.
And gladly, most free stock screeners on the web will allow you to find these stocks. I recommend that you use criteria such as the following to narrow down the selections:
- Current year earnings estimate revisions of 5% or higher
When you get the list of stocks be sure to focus on the ones with the highest estimate revisions. Meaning that 5% revision is nice, but there may be ones experiencing positive revisions of 20% +. However, at some points of an economic cycle there may be too many stocks that make the grade. If so, then consider adding the following criteria to truly find the best of the best:
- Last quarter earnings surprise of 10% or higher
- Past four quarter average earnings surprise of 5% or greater
And just in case you don’t feel like screening for these stocks now, here are five stocks with great earnings momentum:
- Arrow Electronics (ARW): Large electronics distributor riding the growth of the technology space. Modest earnings surprise this past quarter, but strong guidance has estimates flying higher for the future. Plus shares still attractively priced.
- Joy Global (JOYG): If you haven’t been living under a rock, then you probably know there is a great deal of inflation in commodity prices. That certainly includes natural resources that get mined out of the earth. And this leading manufacturer of mining equipment is enjoying a boom in sales and profits.
- Netflix (NASDAQ:NFLX): The shorts keep ganging up on this stock because of the high P/E. Yet quarter after quarter they blow away earnings expectations leading to higher estimates and higher share price. And there's no sign of that trend stopping any time soon.
- Varian Semiconductor (NASDAQ:VSEA): There is a resurgence in tech spending from both the consumer and corporate markets, which increases the demand for semiconductors, and that increases the demand for semiconductor equipment. That cycle is in full swing with estimates flying higher for a firm like VSEA.
- Wynn Resorts (NASDAQ:WYNN): A big player in the Macau gaming market where there is explosive growth. Plus Vegas is making a comeback as the U.S. consumer is waking up from his long slumber. The earnings momentum doesn’t get much stronger then you will find here.