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One profitable trading strategy is to buy stocks with high earnings surprises. Buying stocks after the earnings announcement "beats the street" capitalizes on a phenomenon in which the stock price drifts upward. This pattern is called the Post Earnings Announcement Drift, or PEAD.

Some have used this anomaly to support the idea of an inefficient market. They claim that investors are not immediately reacting and pricing this new information into the share value. This inefficiency can be taken advantage of if you buy stocks with high earnings surprises and hold them for two months.

The counter-argument is found in a November 8 2010 abstract entitled On the Predictability of Analyst Forecast Errors and the Post-Earnings-Announcement Drift, by Yaniv Konchitchki, Lou, Gil and Ronnie Sadka. They attribute much of the gain to predictable error, momentum and other variables that lead to a risk-based explanation of the phenomenon rather than sole investor under-reaction.

Whatever the case, whether it is from a small inefficiency or due to a higher risk-to-reward profile, let’s investigate some recent earnings surprises that have historically led to excess gain.

(You may also want to read about the stock picks and strategies of Trading Earning Surprises on U.S.-listed Canadian Stocks and the supporting research.)

Scanning for Post Earnings Announcement Drift (PEAD)

This is the criteria I used to capture those stocks with big earning surprises:

  • Last earnings reporting date since April 1, 2011
  • Last quarter analyst consensus greater than 20 cents
  • Fiscal year consensus greater than $1
  • Last year's and this year’s earnings growth is positive
  • Recent earnings surprise greater than 50%
  • Price over $5 and volume over 100,000 daily

*Data is supplied by Zacks and may differ from other sources

Company Name

Ticker

Last EPS Surprise (%)

ENCORE WIRE CP

WIRE

130

COINSTAR INC

CSTR

119.05

AGCO CORP

AGCO

118.92

MUELLER INDS

MLI

102.27

POLARIS INDUS

PII

91.43

WYNN RESRTS LTD

WYNN

89.04

MEADWESTVACO CP

MWV

86.96

TITAN INTL INC

TWI

85

EMBRAER AIR-ADR

ERJ

70.59

MOTOROLA SOLUTN

MSI

70.37

LITHIA MOTORS

LAD

70

AMCOL INTL CP

ACO

65.22

METHANEX CORP

MEOH

60.87

BRIDGEPOINT EDU

BPI

55.93

SVB FINL GP

SIVB

55.1

LEGGETT & PLATT

LEG

50

Trading the PEAD

No Large Caps. If you believe that the post earnings drift is simply a risk-factored reward, then you may want to shy away from the larger-cap stocks using this particular strategy. Market cap is simply share price multiplied by the amount of shares. High market cap stocks would include: WYNN (17.84 billion) and MSI (15.1 billion). All the others are mid-cap or less with a range of 6 billion down to 443 million).

Momentum. You can increase your likelihood of excess gains by incorporating the momentum strategy. Momentum is the anomaly where stocks that vastly outperform the market over the previous 52 weeks continue to do so over the next year. The highest 52 week momentum stocks are TWI (+156%), LAD (+113%), PII (+84.52%), WYNN (+69%) and AGCO (60% gain).

Low PEG ratios. Then we have the PEG ratios to consider. Stocks with PEG ratios under 1 are (as reported by Finviz which may differ from Yahoo due to LT growth variances): LAD, AGCO, MEOH and BPI.

A rule of thumb is that the long-term growth should equal the PE ratio. Anything over this may indicate overvaluation and anything under may indicate undervaluation. Or it may simply show that higher risk is being factored in and a higher reward profile is present.

(If you like earnings growth, you may want to examine these 24 proven growth companies at potential bargains.)

Support. These levels are important to reference when buying. A purchase near a support may create a safety net and decent entry. LAD is somewhat above its $14 support, AGCO has made multiple bounces off the $50 level, and SIVB is only a few percent above its support level.

Wrap Up: Post Earnings Announcement Drift (PEAD) continues to be an interesting stock market oddity that some incorporate into profitable trading strategies. Do you trade using PEAD? What have you found to be useful?

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Source: Trading PEAD: 16 Stocks With Earnings Surprises Over 50%