Author: Robert Gay, GEARS
Model: Earnings Surprise
Disclosure: Long DAKT, COHU, SMP, FWRD, BMI, NANO, LLTC, MXIM, LOJN
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.
There is a large population of surprise patterns among U.S. companies now, 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.
The short market correction associated with the Japan disaster provided opportunities to buy Daktronics (NASDAQ: DAKT), COHU Inc (NASDAQ: COHU) Standard Motor Products (NYSE: SMP), Forward Air (NASDAQ: FWRD), Badger Meter (NYSE: BMI), Nanometrics (NASDAQ: NANO), Linear Technology (NASDAQ: LLTC), Maxim Intergrated Products (NASDAQ: MXIM) and LoJack (NASDAQ: LOJN).
The Earnings Surprise strategy is a perpetual start-up model. Because extended shares are sold to provide room for new surprise patterns, the model is always making trades in stocks in the surprise category. Negative surprise patterns have appeared more frequently this period as the unusually high frequency of rising sales growth has declined. Over the past year, with the majority of U.S. public companies reporting both rising sales growth and rising gross profit margin, the population of negative surprise patterns was unusually low.
In the annual period just completed, the proportion of rising sales growth fell and the gross margin advance occurred at approximately half of companies. With share prices broadly extended, negative surprise opportunities have become more common.
To generate value from negative surprises, I have purchased put options on Sturm Ruger (NYSE: RGR), Quest Diagnostics Inc (NYSE: DGX), Fluor Corp (NYSE: FLR), Diamond Offshore Drilling (NYSE: DO), and LSI Logic Corp (NYSE: LSI). These act as a hedge against a market decline and a stock specific value generator for the negative surprise.
Note from Covestor: As Covestor mirroring accounts do not replicate options trades, subscribers cannot acquire these put options. This may contribute to performance drift. For more information, see our page on performance drift: http://site.covestor.com/help/performance-drift