Use Surprises to Pick Stocks

Here’s a stock picking strategy that doesn’t require scrutinizing financial statements or checking price/earnings ratios, or even worrying about how economic ups and downs might affect a company’s outlook. 

Instead, it’s based on picking stocks based on earnings surprises, one of the few reliable predictors of future stock prices.

An earnings surprise is the difference between a company’s reported earnings and the number that stock analysts were expecting. All else equal, positive surprises (reported earnings beat forecasts) drives share prices up, often for extended periods. Conversely, negative surprises (earnings below forecasts) drive share prices down.

Blogger's Surprise Strategy
Hedge funds, said to rely heavily on surprises to power their computer driven stock selection strategies, keep the details secret. But that’s not the case for Pradeep Bonde, who publishes a blog called StockBee (StockBee.blogspot.com). Bonde follows a strategy based on tracking surprises that, reportedly, has been producing high double-digit annual returns for several years.

I can’t verify Bonde’s returns, but his ideas are intriguing enough to share. If you’re interested, give it a spin with paper (imaginary) trades to see how it works for you. Here are the details.

Finding Surprise Stocks
Bonde monitors quarterly earnings announcements, which for the most part, happen when the markets are closed. Bonde says that Investors Business Daily (www.investors.com) and the Wall Street Journal (www.wsj.com) do the best at presenting earnings report numbers, but those sites require a subscription. You can also monitor the reports on free sites including the Earnings Analysis report on Zacks (www.zacks.com), the Earnings section of StreetInsider.com (www.streetinsider.com), and the Market Pulse report on MarketWatch (www.marketwatch.com).

Bonde starts by looking for stocks with a minimum 100% earnings surprise. That is, reported earnings must be a least double consensus (average) analyst forecasts. Bonde cites studies that found that the bigger the surprise, the higher the potential share price gain. One further point: the latest earnings number must be at least five cents per share. Bonde doesn’t think that a 100% surprise means much if the forecasts only called for earnings of a penny or so per share.

A strong earnings surprise is just the start. Bonde requires several additional conditions before he’ll buy a stock. 

First Surprise
Some companies routinely beat analysts’ forecasts. For them, another positive surprise isn’t news. Thus, Bonde looks for real surprises, that is, stocks that haven’t reported consistent positive surprises in previous quarters. You can see a firm’s surprises for the last four quarters in the Earnings History section of Yahoo’s Analyst Estimates report (finance.yahoo.com).

Guidance
Most firms forecast the next one or two quarters’ sales and earnings when they announce the most recent quarters’ results. The big earnings surprise doesn’t mean much if company management expect a slowdown in future quarters. Disqualify stocks if the company’s guidance for future growth isn’t consistent with the just reported results.

Small Stocks 
Shares outstanding are the total number of shares issued by a company. But company insiders are only allowed to trade their shares under certain conditions. Thus shares held by insiders are not considered available for trading. Float is the number of outstanding shares not held by insiders, and thus, are available for trading. Floats can run into the hundreds of millions of shares. For example, Apple’s float is 900 million shares. Bonde prefers floats below 25 million, and ideally below 10 million. He avoids stocks with floats above 100 million shares. You can see the float in the Share Statistics section of Yahoo’s Key Statistics report.

Price Move
Bonde requires qualifying stocks to move up at least 8% after the earnings announcement containing the surprise for stocks that were trading under $63. For stocks that were trading above $63, a $5 price jump is sufficient.

Trading Volume
Besides for the price jump, Bonde wants to see trading volume (number of shares traded daily) on the day following the news jump to several times higher than before the announcement. You can see the current day’s trading volume, as well as the average volume over the past three months on Yahoo’s Summary report.

Previous Action
Bonde says that in terms of previous price action, the best candidates are stocks that basically moved sideways in the months previous to the surprise announcement.

Selling
Bonde typically holds his stocks for periods ranging from two days to several months. However, he sells immediately if a stock drops by 6% or more after he buys. If it moves up, Bonde sets sell price targets based on the earnings surprise percentage. For instance, for a 100% surprise, he’ll sell 25% of his holding when he achieves a 50% share price gain, and then sell another 25% when it goes up another 25%, and so on. However, for a 200% surprise, he’ll wait until he achieves a 100% gain before selling 25% of his holding. Bonde also sells when the stock stops steadily moving up in price, even if it hasn’t reached his target.

I don’t have room to detail all of the ins and outs of Bonde’s strategy. You can find out more by reading his Blog, or you can be privy to his trades by subscribing to his premium service, which costs $150 per year.

By the way, I learned of Bonde’s work after Charles E. Kirk, proprietor of The Kirk Report (www.thekirkreport.com), posted an online question and answer session with Bonde.

published 2/28/10