We’ve all seen it happen dozens of time. A stock sells off sharply after missing analysts’ expectations. Sometimes, earnings per share (EPS) come in just a penny below expectations. But that small miss can cost investors hundreds of millions of dollars.
Of course, we’ve also seen the opposite happen. A stock soars after the company delivers EPS that beat expectations. It seems that beating expectations is all it takes for some stocks to end up on the list of the market’s biggest gainers on the day after they report earnings.
As we look at these news stories, we noticed a common theme. Traders were reacting to how the earnings were compared to expectations. Often, no one even seems to know what earnings were. All that matters is whether the company beat expectations or missed analysts’ estimates.
There’s a valid reason for this. Traders look ahead and buy stocks with good earnings prospects. They sell stocks with less favorable prospects. While historical earnings are important, it’s also important to remember that traders look ahead. A stock’s price is based on how the company is expected to perform in the future.
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Now, no one knows what the future holds. But, for many stocks, analysts try to forecast the future. They will use past performance as a starting point in many cases. Then, they look at industry trends and trends in the overall economy. They talk to management to learn about their outlook. Analysts assemble all of these pieces of information into a research report and that report often contains an estimate of EPS for the next quarter, the next year and beyond in many cases.
Analysts’ estimates then become an important piece of data for other market analysts and for traders. Estimates are collected by data providers and available through many services. Traders can even find estimates for free at a number of web sites.
For most stocks, more than analyst covers the company. The data providers usually average the available estimates and publish that as a “consensus forecast.”
The estimates usually become the basis of valuation models for a stock. For example, if a company has a consensus estimate for EPS of $4, assuming an analyst believes the stock should trade with a price-to-earnings (P/E) ratio of 12, the price target would be $48.
This system explains why stocks can rise or fall so much after an earnings report.
According to the Efficient Market Hypothesis (EMH), a stock’s current price reflects all of the information available about that stock. In theory, so does an analyst’s earnings estimates. Now, maybe an analyst will miss something which is why the data providers aggregate the estimates and publish a consensus estimate.
When a company misses or beats expectations, traders are given new information. They must incorporate that new information into their estimate of a stock’s value. They do this quickly, and that explains the large moves we see in stocks when earnings are announced.
One way to benefit from this is by tracking analysts expectations. When they are consistently raising expectations, they are incorporating more and more good news into their expectations. Researchers have found that stocks of companies where analysts are increasing earnings estimates tend to go up. In one study, a portfolio of the stocks with the greatest positive changes in earnings generated returns that were nearly five times as large as the average gain of the S&P 500 index.
We created a screen for this type of stock. This week, we searched our database for stocks analysts have been increasingly bullish about. We limited our picks to stocks followed by at least 4 analysts to avoid stocks with limited analyst coverage. Then we searched for low-priced stocks since they are capable of delivering large percentage gains on relatively small earnings surprises. We found 7 stocks priced under $10.
Safe Bulkers, Inc. (NYSE: SB) provides marine drybulk transportation services, transporting bulk cargoes, particularly coal, grain and iron ore, along worldwide shipping routes. The company’s operational fleet is comprised of 38 drybulk vessels, with an average age of 6.6 years and an aggregate carrying capacity of 3,421,800 million dwt. The fleet consists of 14 Panamax class vessels, nine Kamsarmax class vessels, 12 post- Panamax class vessels and three Capesize class vessels, all built since 2003 so they are relatively new. New ships are less likely to be salvaged and this reduces the risk in SB.
Plug Power Inc. (Nasdaq: PLUG) is an alternative energy technology provider that engages in the design, development, commercialization, and manufacture of hydrogen fuel cell systems primarily for the material handling and stationary power markets in the United States. The company focuses on proton exchange membrane (PEM) fuel cell and fuel processing technologies, fuel cell/battery hybrid technologies, and related hydrogen storage and dispensing infrastructure. Alternative energy is a volatile industry and it could be best to stick with stocks covered by analysts in this emerging sector.
Eldorado Gold Corporation (NYSE: EGO) engages in the exploration, development, and mining of gold, as well as iron, silver, lead, and zinc in Turkey, Greece, Brazil, Serbia, and Romania. Cheap gold stocks have the ability to deliver large gains when gold is in a bull market as some analysts believe it is now.
Angie’s List, Inc. (Nasdaq: ANGI) is a local services consumer review service and e-commerce marketplace in the United States. The company allows consumers to research, shop for, and purchase local services for home, health, and automotive service needs, as well as to rate and review service providers in markets. In addition to being a buy based on our analysts’ screen, ANGI is always a potential takeover target.
ADAPTIMMUNE LTD (Nasdaq: ADAP) is a clinical-stage biopharmaceutical company, focused on the provision of cancer immunotherapy products based on its proprietary SPEAR T-cell platform. The company utilizes T-cell therapy to treat cancer and has multiple trials ongoing in both solid tumours and hematologic cancer types, and in cancers where survival rates for patients can be very limited. The T-cell therapies have shown preliminary evidence of tumor reduction in patients and shows a promising risk/benefit profile. Drug companies can pop higher on news about FDA approvals. Analyst coverage means there is an independent opinion on those complex drug trials.
Conatus Pharmaceuticals Inc. (Nasdaq: CNAT) is a biotechnology company, focused on the development and commercialization of medicines to treat liver diseases in the United States. Its product candidates include Emricasan, an orally active pan-caspase protease inhibitor that is in Phase IIb clinical trials for patients with portal hypertension; for liver function; for patients liver fibrosis caused by nonalcoholic steatohepatitis; and for post-orthotopic liver transplant as a result of hepatitis C virus infection with sustained viral response.
Scorpio Bulkers Inc. (NYSE: SALT) is a shipping company that owns and operates dry bulk carriers. Its vessels transport a range of bulk commodities, including ores, coal, grains, and fertilizers along worldwide shipping routes. SALT should do well if the global economy continues to grow.
Any of these stocks could end up on the list of biggest winners when they announce earnings. Of course, any of them could also be on the list of biggest losers if they disappoint analysts. To minimize risk, we recommend buying several stocks to increase the probability of finding at least one big win. You could also screen for value or some other criteria to minimize.
In the long run, a portfolio of stocks like this has done well. Analysts’ expectations are an important part of traders’ expectations and stocks with rising estimates are likely to continue outperforming the broad stock market trading in the future.