Author: Robert Gay, GEARS
Model: Earnings Surprise
Disclosure: Long ENER
I created the Earnings Surprise Model to exploit the earnings surprise pattern in fundamental data. The components of the surprise pattern are rising sales growth, higher gross profit margins, high and falling SG&A expenses, lower financing costs and positive and rising cash flow returns. This pattern repeats itself frequently not only across companies but also within the company record as economic cycles and product cycles affect growth.
The surprise pattern measures an accelerating company. This accelerating phase of the company growth cycle is when the company produces a series of positive earnings surprises and often when the shares produce superior returns.
Depressed share price is also an important component of the Earnings Surprise Model strategy. The surprise pattern is not a predictor of the future but rather a measure of the current evident trend. That trend can reverse even in the short term and the depressed share price discipline helps limit the downside risk.
We’ve seen a large number of surprise patterns among U.S. companies recently, and that allows me to strictly enforce the surprise rules. Any evidence of lower profit margins, sales growth peaking or inventory build will prompt a sell for a model position, particularly if the shares are extended. After the strong share price advance of recent weeks, the population of depressed share prices has declined.
In the surprise strategy, I will also sell shares that become unusually extended. This is designed to lower my equity risk. It also provides cash to invest in new surprise patterns as they appear.
With the sell decisions for Power Integrations Inc (POWI), Amkor Technology (AMKR), LSI Corp (LSI), Ivac Inc. (IVAC), Entercom Communications (ETM), Louisiana Pacific Corp (LPX) and Faro Technologies Inc (FARO), I significantly increased the cash available in the model to make new buy decisions for surprise patterns as shares become depressed.
The only recent buy decision in the model has been Energy Conversion Devices (ENER).
To create a successful stock portfolio requires attention, consistency and discipline. Most of all, it requires an information edge. Years of research have shown that shares of companies that are profitable with rising shareholder wealth perform better.
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