A couple weeks ago I wrote "The Art of Successfully Playing Earnings" following a significant amount of interest surrounding my weekly earning plays. The goal was to teach investors the "dos and don'ts" of playing earnings which include a variety of strategies. It discussed when to buy and when to sell, being diversified in your approach, along with a variety of strategies for returning a profit by playing earnings.
But last week I received an email from a reader who asked me "how do you determine which stocks present the most upside potential following earnings?" This was a great question that is obviously way too long to answer in an email. Therefore it's a good thing he requested that I write an article so that I can layout the blueprint for how I decide which stocks to buy prior to earnings.
The series I am writing "Stocks Worth Buying Before Earnings" has been particularly successful this quarter; as a result there is a great amount of interest. Throughout the series I have included various tips, strategies, and trends to watch, but I haven't really talked about how I decide which stocks to choose. There are several factors involved in choosing a stock with the greatest amount of upside prior to announcing earnings. During earnings season there are 100s of companies that announce earnings during a particular week, therefore it can be overwhelming to try and find the best few that present the best opportunity. I use a series of fundamental, psychological, and metric based criteria to find stocks that will return an overall gain following earnings.
When looking for a stock to buy prior to earnings my first area of research is a company's past results. I usually have a list of companies that interest me for any given week. I then take the companies that interest me and research to find how each company performed over the last few years during earnings. I typically use CNBC, because the site has an extensive log of a company's past results. And what I am looking for is companies that consistently beat analysts' expectations by a large margin. At this point I am not concerned with trends, metrics, or any other data. My first and most significant data is to find out if a company outperforms or underperforms expectations on a consistent basis.
After finding a company that consistently beats expectations I then turn my attention to how high or low analysts' expectations are for a particular company. I think investors sometimes forget that expectations are what drives the market, and a stock, higher. When the market trades higher it means that expectations such as employment, GDP, or other indicators are exceeding the expectations that we set. On the contrary, when the market trades lower it's because our expectations are too high and the market is not living up to high expectations. When expectations are consistently met analysts will raise guidance but once guidance gets too high too fast then eventually the market will fail to hit the goal, causing a loss.
The same example should be considered with individual stocks when choosing plays for earnings. The last thing you want is to buy a company that has consistently beat expectations but has expectations that are simply too high. When choosing a possible play I will compare year-over-year performance of a company and consider the growth of the economy and the performance of other companies in the same industry. Understanding expectations is one of the more important areas of research: I want to know that expectations aren't unrealistic and more importantly, I like to choose companies that give solid guidance throughout the year so that I can compare a company's guidance to analysts' expectations.
In my opinion, this particular area of research is the most meaningless, but should still be explored. This area goes hand-in-hand with expectations because you are looking at the stock performance of a company following past earning reports. Quite often a stock will trade very irrationally and will fall despite very strong earnings. It's very difficult to predict how a stock may react to earnings; there are so many other areas that come into play.
However, there are some stocks such as Apple (NASDAQ:AAPL), Caterpillar (NYSE:CAT), and Mastercard (NYSE:MA) that have a solid history of both beating expectations and trading higher after earnings. It's impossible to know when expectations won't be met but if it's not broke then I won't fix it; meaning, I will continue to trade what works, stocks such as AAPL, CAT, and MA. This smallest amount of importance should be placed in this area of research, because even if a stock traded lower following its last two reports doesn't mean that it didn't beat expectations and that it wasn't a result of market conditions that didn't relate to the company.
The single most important measure is momentum or the direction that investors expect a stock to trade prior to and following earnings. This measure will ultimately determine if you return a gain or a loss. Therefore I always try and purchase stocks that I believe may trade higher prior to earnings in anticipation of good earnings. For example, during this last earnings season, I have purchased approximately 24 during stocks over the last five weeks. Of the 24 purchased all but 5 exceeded expectations, but only 15 traded higher following earnings. Therefore, four companies beat expectations yet traded lower, or 15 traded higher of the 24 stocks that were bought prior to earnings. This proves that momentum plays a large role in determining a stock's reaction following earnings.
I have been playing earnings for several years and one trend that always seems to produce the largest gains is when a stock trades flat prior to earnings. I returned large gains on several stocks that traded lower following earnings such as Sprint Nextel (NYSE:S). Sprint announced earnings on February 8 and traded higher by 11% in the three days prior to announcing earnings as a result of optimism that the company would announce higher revenue, a narrow loss, and a major increase in new subscribers. I was very impressed by Sprint's quarterly results, however, the market responded with an initial loss before recovering to close with a loss of $0.04 following its earnings report.
The loss following Sprint's earnings report was because a better than expected quarter was already priced into the stock. Other stocks that traded lower, but beat expectations, were EOG Resources (NYSE:EOG) and Weight Watchers (NYSE:WTW). Both stocks traded lower after beating expectations because solid results were already priced into the stock with gains in the 3 days prior to earning results. When this occurs a company must exceed expectations by a very large margin in order to maintain the momentum. Based on my experience, if a stock runs up by an excessive margin prior to earnings it may prove to be a mistake to purchase the stock the day prior to earnings. Therefore, unless you buy these stocks several days prior to earnings you may buy too late and return a loss despite strong results.
I am fairly certain that the majority of stocks that fall after beating expectations are stocks that trade higher prior to earnings. The largest gainers are usually those that trade somewhat flat prior to earnings. During the last 5 weeks of my series the best performers have been Level 3 (NASDAQ:LVLT), Fossil (NASDAQ:FOSL), Green Mountain Coffee Roasters (NASDAQ:GMCR), Apple , and Netflix (NASDAQ:NFLX). What I find interesting is that each of these stocks traded relatively flat in the few days prior to earnings but then popped huge after earnings were announced.
Therefore, I suggest playing earnings one of two ways: You can either buy a few days prior to the announcement and hope to ride the trend higher or buy the day before but only if the stock is trading flat. I prefer buying a few days prior whenever the market is trading lower because if it trades higher then it will most likely return gains regardless of its reaction after earnings are announced.
One of my most uneducated picks of this earnings season was Amazon (NASDAQ:AMZN). The stock trades at a ridiculous price above earnings and is not cheap in terms of price/sales. It was an emotional decision based on my belief that more consumers purchased goods online through Amazon during the holiday season. But when a momentum stock such as Amazon doesn't beat expectations by a very substantial margin then it will almost always trade lower.
The trading metrics of a company is very important in determining whether or not a stock is presenting a good opportunity. When I purchased AMZN I should have considered that its profit margin had been steadily declining and its growth had been showing signs of weakness. Therefore, when choosing stocks that present a likelihood to trade higher, after earnings, it's important to find stocks that are trading with a balanced amount of optimism but aren't overly optimistic.
I try to avoid stocks that are deemed momentum stocks that trade exceptionally high above earnings. However, I did buy NFLX and GMCR because I felt that its loss and lower expectations gave both stocks an opportunity for gains. Amazon did not fit into this category and should be used as a lesson of what to avoid when buying a stock prior to earnings.
It's important to remember that no matter how good an investment may appear or how sure you are that a company will exceed expectations it may still trade lower. I urge you to take the time and read "The Art of Successfully Playing Earnings" to better expand your knowledge of this particular strategy. I have been practicing this strategy for many years and I've found that it's impossible for it to be mastered. I simply use the criteria above and incorporate the strategies that I have discussed and then understand that I am going to pick a few losers along the way.
The goal is to choose more winners than losers and return an overall gain and to not invest too much of a portfolio into this strategy. I only use a small percentage of my portfolio to play earnings but if done correctly it can return consistent gains and allow you to capitalize on fundamentally growing companies that are poised to trade higher.