How to Make Earnings Surprises Pleasant

Let's start this article on solid ground by stating the obvious: We are heading into the thick of first-quarter earnings season. And with that comes trading opportunity. In an April 6 article I discussed some strategic approaches to dealing with inevitable blowups. (Harley-Davidson's(HDI Quote) wipeout this week was another example.)

Now, though, I want to take a more proactive approach and look to establish positions in anticipation of earnings reports that could produce both upside and downside surprises.

While I do a lot of my own research in searching out trading ideas, when earnings season comes along, I like to lean on the computational power that a large firm with an army of analysts and quant jocks can bring to the table. This helps me sift through the numbers of the thousands of companies that report in a four-week time span.

In the past I've turned to work done by Keith Miller of Smith Barney. Miller and his team produce a reliable list of stocks most likely to deliver earnings surprises. It is a quantitative model that uses several basic criteria to come up with candidates that that will deliver a "standardized unexpected earnings," or SUE, as the model is known. It provides a great starting point to scan for trading ideas.

A Model Named SUE

The basic criteria for SUE are sales and earnings momentum, the direction of profit margins, price momentum and previous quarterly results. The historic or realized SUE is based on the most recent 16 quarterly earnings reports. For a more detailed discussion of SUE's methodology, look at this June 2004 article.