Earnings season is generally a time of increased volatility in the stock market. Traders know this from experience and it fits into standard financial theories.
The academic community has demonstrated that stock markets in developed nations are informationally efficient. This means the current price reflects all of the information about a company. This is logical and there are alternative explanations but this one seems to fit the data very well.
Notice that the theory merely says stock prices reflect what is known about the stock. It does not state that this is absolutely the correct price of the stock. The current price may or may not reflect the company’s accurate value. But, the current price reflects the price traders agree to buy or sell at.
If we consider a market to be informationally efficient, we should expect prices to change suddenly in some cases when earnings are released. Earnings represent new information and it is the market’s job to incorporate that new information into the current market price.
This process should happen quickly. Experience confirms that it does happen quickly. Often with a large change in price at the open, forming a pattern that technical analysts call a gap. The gap is an area on the chart where no trades took place and it is readily apparent in the chart below.
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In this chart all of the gaps were driven by news. The most recent gap is unusual in its size. But gaps are common for stocks.
Investors can enjoy large gains if they own stocks that gap higher on news. This fact drove our search for potential winners this earnings season. Our goal is to identify stocks that could potentially gap up in news. Remember, there is no guarantee a gap will occur but we attempted to quantify factors that could lead to a gap.
Also, it is important to remember when we search for stocks using quantitative measures, our goal is to identify stocks that meet those criteria. The screens we develop could be used as the cornerstone of long term investment opportunities but any individual stock in the list could be a winner or loser.
Quantifying Potential Gaps
To search for stocks that can make large moves on news, we limited our search to low priced stocks. The reason we like cheap stocks is because these are the ones that have been proven to be most likely to deliver large gains.
One study looked at how low priced, or cheap, stocks performed relative to more expensive stocks. The study found that cheap stocks delivered more than six times the average return of the more expensive stocks in a typical quarter. But, remember that low prices can indicate low quality companies and high risk stocks.
We limited our search to stocks trading under $10 a share. We then searched for stocks that delivered an earnings surprise of at least 25% for two quarters, have seen upward revisions of at least 25% in the past month and show strong relative strength.
Earnings surprises are the fuel for gaps. Beating expectations forces analysts to revise their price models, usually higher. Missing expectations can result in downward revisions and that could lead to sell offs in a stock. We focused on better than expected earnings to find potential up side gaps.
Upward revisions are a sign that analysts are expecting additional surprises in a company. Combined with a history of upside surprises, these could be companies that are set to outperform their peers.
Finally, we limited our search to stocks that have outperformed their peers over this past year. These stocks rank high on relative strength or momentum.
Momentum is among the most robust patterns that academic researchers have identified. Momentum simply refers to the performance of a stock over the recent past. For example, stocks that have outperformed the market over the past twelve months are likely to outperform over the next twelve months.
Likewise, stocks with low momentum are likely to see that pattern continue over the near term. So, stocks that lagged the market over the past six months are likely to continue underperforming in the next six months.
These are general tendencies and there will be stocks that move opposite to the general tendency. This is not proof that momentum works. This pattern is best when applied to a portfolio of stocks.
This Week’s Trading Candidates
Our screen identified just a few stocks.
Westell Technologies, Inc. (Nasdaq: WSTL) designs and distributes telecommunications products to telephone companies in the United States. The company operates through three segments: In-Building Wireless (IBW), Intelligent Site Management and Services (ISMS), and Communications Network Solutions (CNS).
Each division serves wireless and wireline service providers, multiple systems operators, Internet service providers, systems integrators, neutral host operators, and distributors through field sales organization, distributors, and partners.
WSTL gapped higher on its last earnings report and continued higher for several weeks.
Intermolecular, Inc. (Nasdaq: IMI) provides high productivity combinatorial (HPC) technology platform for the semiconductors, consumer electronics, automotive, and aerospace industries worldwide. It serves various markets, including flat glass, advanced alloys, light-emitting diodes, flat-panel displays, and others.
IMI is a volatile stock as the chart below shows.
Profit taking orders could be considered with a stock that trades like this to capture short term gains as they become available.
Papa Murphy’s Holdings, Inc. (Nasdaq: FRSH) owns, operates, and franchises Take N Bake pizza stores.
As of May 10, 2017, it operated approximately 1,500 stores franchised and corporate-owned pizza stores in 39 states, Canada, and United Arab Emirates.
On average, FRSH gains about 3.3% in the week after the company announces earnings.
Golden Ocean Group Limited (Nasdaq: GOGL) owns and controls a fleet of 70 vessels, including newbuildings and vessels chartered on long term time charter contracts. The company transports bulk commodities, such as ores, coal, grains, and fertilizers along worldwide shipping routes.
GOGL is in many ways a trade on global commodity prices and the stock has been in an extended bear market since commodity prices turned lower in 2014.
This adds risk to the trade but also makes the stock likely to be among the volatile trading opportunities in earnings season.
USA Technologies, Inc. (Nasdaq: USAT) provides wireless networking, cashless transactions, asset monitoring, and other value-added services in the United States and internationally.
It designs and markets systems and solutions that facilitate electronic payment options, as well as telemetry and machine-to-machine (M2M) services.
On average, USAT gains more than 10% in the week after the company announces earnings.
Adesto Technologies Corporation (Nasdaq: IOTS) provides application-specific and ultra-low power non-volatile memory products. The company’s products include DataFlash for data-logging applications, such as industrial automation, home automation sensing, and health and fitness tracking; Fusion Flash for use in various high-volume consumer applications comprising wearables, mobile, and other applications; and EcoXip that enables enhanced processor performance and reduced system power consumption.
It also provides conductive bridging random access memory based products, which include Mavriq for Internet of Things and other applications, which include camera sensors, Bluetooth low energy devices, wearables, gaming components, printer cartridges, medical equipment, and other devices.
This stock is also volatile and could be used with profit taking orders to limit the risk of a steep pullback that often follows moves higher.
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