United Natural Foods (NASDAQ:UNFI) reported less than expected earnings last week, and that negative earnings surprise drove the stock down 25%. Since short the stock, I am elated, and one of the several reasons I am short is that the stock had missed earnings expectations the last couple quarters and analysts had been revising downward their future estimates.
Stocks that have earnings surprises in a given quarter, either positively or negatively, often do so again, in the same direction, in the future. Though stock prices react, they don't quite incorporate the new probabilities of likely future earnings, so there exists the chance to buy stocks with positive earnings surprises (or short stocks with negative surprises) and still earn excess returns over the coming quarter, until the next "surprise".
Why this is so is debatable - behavior finance suggests investors sometimes under-react to unexpected news, and thus the continuation of earnings surprises, in either direction. As an investment strategy alone, earnings surprise is a bit flimsy, since often companies don't repeat the surprise, or sometimes it is better for investors to adjust their expectations (or for companies to manage their earnings better to avoid negative surprises). But in combination with other valuation metrics, past earnings surprises can increase the odds that a stock will outperform if cheap, or potentially will plummets, like UNFI, if it's richly priced to begin with.
In the same industry, another short position I have is Whole Foods Market (WFMI) which recently negatively surprised again for the 4th time in 5 quarters. A long position I own in the industry, Kroger (NYSE:KR), has had a nice series of positive surprises and has significantly outperformed both UNFI and WFMI over this period. Food for thought.