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.