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Seek out Surprise Stocks

As a UK investor you can easily monitor quarterly earnings announcements, which for the most part happen when the markets are closed. US-based publications such as Investor’s Business Daily and the Wall Street Journal constantly follow these numbers, and online services such as Zacks also do a sterling job. Alternative sources are the earnings section of StreetInsider.com and the Market Pulse report at MarketWatch.

Earnings surprise is a popular criterion for selecting stocks to trade because the market watches earnings reports closely, and positive (or negative) earnings relative to market expectations tend to send stocks higher (or lower). Focusing on companies that produce a big earnings surprise sounds elegantly simple, and it works.

Analysis of the 3,000 largest US‐listed names shows that those sporting an earnings surprise usually experience substantial share price increases over the subsequent month. The top‐rated 20 per cent outperformed the bottom 20 per cent by 0.21 per cent per month, every month, from August 2000 to December 2011.

Many hedge funds make their investors a great deal of money by focusing on companies boasting an earnings surprise, but academic research reveals that much of the strategy’s added value comes from the least liquid stocks. Therefore, running this strategy on a very large basis is difficult.

The most positive returns are from the most illiquid shares, which are likely to be the most difficult and expensive to trade in; that is, they have the highest bid‐ask spreads.

If you pursue securities in order to take advantage of the price increase or decrease that typically follows an earnings surprise, be aware that the price may not go in the direction you anticipate and that, because of the often-illiquid nature of these stocks, you may put yourself at risk for extensive losses.

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