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) 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.

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.

On the Catwalk

This quarter's list contains 57 candidates for positive surprises and 21 candidates for negative surprises. While the total list of 78 companies is slightly smaller than usual, the 21 negative candidates represent over 26% of the list of names generated, which on a percentage basis is the largest number of negative surprises expected in the last 12 quarters. You'll need to contact Smith Barney if you want the complete list, but here are a few names I am focusing on:

Yum! Brands ( YUM) is expected to earn 52 cents per share when it reports April 20. SUE is calling for a positive surprise. The stock is approaching good support at $50, and if the company can deliver another upside surprise, shares could make a run toward new highs.

But given that the overall chart pattern is developing into something of a head-and-shoulders formation, I'd use the limited risk strategy of buying calls to play this one. The options remain cheap with the May $50 currently trading for around 75 cents, providing a good risk/reward equation for a short-term trade.

Allmerica Financial ( AFC) is slated to report on April 26. The company is expected to earn 75 cents a share. Again, SUE is looking for an upside surprise. Since breaking out to the upside in late February, the stock has been forming a bullish flag/bowl above support at $35.

With the stock trading at $36.80, you can the purchase the May $35 call for $2.30 per contract. This gives a break-even point of $37.30, requiring a rally of just 50 cents, or 1.3%, to turn a profit. Even if the stock fails to hit new highs, as long as the stock holds support at $35 the option should be worth at least $1 until the May 20 expiration is less than two weeks away.

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.

Steven Smith writes regularly for TheStreet.com. In keeping with TSC's editorial policy, he doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He was a seatholding member of the Chicago Board of Trade (CBOT) and the Chicago Board Options Exchange (CBOE) from 1989 to 1995. During that six-year period, he traded multiple markets for his own personal account and acted as an executing broker for third-party accounts. He invites you to send your feedback to steve.smith@thestreet.com.

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