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The Other Kind of Stock Price Momentum by - By Zacks Investment Research
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 our portfolios with as many stocks experiencing positive earnings momentum as possible. That's because this one element is the key catalyst behind share price momentum.
How do we find more of these stocks?
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 keeps 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 holding 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 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. The essence of his finding was placed into our Zacks Rank stock picking model.
You've probably heard us pound our chest about the +26% annual return for the #1 Ranked - Strong Buy stocks. We couldn't say it if it wasn't true.
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So the Question Becomes: What to Do Next?
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