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) 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. June 2004 article .
SUE normalizes earnings surprises by considering the level of analyst uncertainty. That leads to the assumption that the narrower the range of analyst estimates (meaning that everyone is pretty much in agreement about what the company will report), the greater the impact any surprise or deviation from that mean will have on the stock price. Since the model's inception in January 1996, 78% of the companies predicted to post a positive earnings surprise did in fact come through. This compares with about 57% of Russell 1000 companies posting positive earnings surprises in the same period.
Outback Steakhouse ( OSI) is expected to report a profit of 67 cents per share when it announces earnings on April 20. SUE thinks the food chain won't deliver. The stock has been putting in some lower highs, and the hype from the Atkins diet, which helped propel shares an all-time high in March 2004, has dissipated. Beef prices remain high, though, and this could lead to lower revenue and, more importantly, margin compression. Look at the May $45 puts for less than a buck for a cheap way to play an earnings shortfall or lowered guidance.