When hunting for stocks to buy now, don’t overlook the upside earnings surprise.

An earnings surprise occurs when a company reports quarterly profits – its earnings per share – higher than the consensus of the Wall Street analysts who cover that company.

So the idea that when a company beats on earnings it’s likely to boost the stock price seems pretty straightforward.

But I’m not just talking about the pop immediately following the earnings announcement. Research dating back to the 1960s suggests that upside earnings surprises result in share price outperformance over the following six to 12 months.

But to wring the maximum benefit out of this idea, you need an edge. And that’s what I’ve got for you today.

I’m going to show the one factor that makes some earnings beats much better than others.

I’m also going to show you how to find the companies most likely to deliver a strong upside surprise on their next earnings report.

After all, there’s no advantage to buying a stock along with everyone else on the day a company has an upside surprise. By buying your shares weeks ahead of time, you’ll enjoy any anticipatory gains leading up to that surprise, in addition to the pop on the day the company reports and the extended gains thereafter.

Finally, I’ll give you five stocks to buy now that fit the criteria.

Not All Upside Surprises Are Equal

As most investors know, upside surprises are common. In fact, it’s the norm. According to FactSet, 79% of S&P 500 companies reporting earnings for Q4 of 2020 beat earnings-per-share estimates.

Companies know investors watch these numbers closely. So they put a lot of effort into making sure they “beat the Street.”

Companies employ an array of methods to beef up earnings numbers, starting with stock buybacks (which reduce the total number of shares, thus increasing earnings per share even if profits remain flat). Companies can also simply cut costs or shift revenue or expenses to a different period, among other accounting tricks.

So one thing investors should look for is substantial earnings beats, not just a few percentage points. Since FactSet says the five-year average earnings beat is 6.3%, you want to see something well above that, in the double-digits or higher, to consider it a “quality” beat.

The other telltale sign of a quality earnings beat is if the company beats on revenue as well as earnings. Revenue is more difficult to manipulate than earnings, so an upside surprise there suggests the company’s increased profits are the result of genuine growth in the business.

One of the studies on the positive effect of upside surprises on stock prices – known as post-earnings-announcement drift (PEAD) – focused on how adding a revenue beat to an earnings beat affected the stock price in the following months.

Not surprisingly, the study found that revenue beats amplified earnings beat-related stock price increases.

Knowing this, my next step was to come up with a screen that would point me to stocks that have a high probability of beating on both revenue and earnings the next time they report.

Casting a Net for Upside Surprise Stocks

The first thing I did was to eliminate large-cap stocks (market caps of $10 billion or more). The PEAD research has shown that the bigger the company, the less impact an earnings beat has on the stock price.

I screened out penny stocks by requiring the share price be more than $5. I also screened out stocks with very high price/earnings ratios, because we’re looking for value.

Then I added the upside surprise elements. Of course, I screened for stocks that had upside surprises in their most recent earnings reports.

But we are trying to peer into the future here. So I added screens for stocks with EPS and revenue estimates that have been revised upward for the current quarter as well as the next quarter.

The goal was to pinpoint companies likely to report strong upside surprises in their next earnings report.

I was left with about 30 companies. I narrowed that list down to the five stocks with the best chance of producing upside surprises with the biggest impact.

5 “Upside Surprise” Stocks to Buy Now

No. 1: Lazard Ltd. (NYSE: LAZ)

Bermuda-based Lazard is an international financial advisory and asset management firm with roots dating back to 1848. When it last reported earnings in February, LAZ had an upside EPS surprise of 70% and a sales upside surprise of 24%. Over the past 60 days, analysts have bumped up EPS estimates for the current quarter 19% and revenue estimates 7.5%.

The one-year consensus price target on Lazard stock is $49.67, a 15% gain from the current price of about $43. However, an analysis by the website Simply Wall St. has a fair value on LAZ of $72.82, representing a potential gain of about 69%. Lazard pays an impressive dividend of 4.45%. The company’s next expected earnings date is April 30.

No. 2: Century Communities Inc. (NYSE: CCS)

This Colorado-based construction company is focused on residential construction. When it last reported earnings in February, CCS had an EPS upside surprise of 49% and a sales surprise of 6%. Over the past 60 days, EPS estimates for the current quarter have risen 43%, while revenue estimates have gone up 32%.

The one-year price target on Century Communities is $70.67, a 12% gain from the current price of $63.80. Simply Wall St. has a fair value of $169 for the stock, a potential gain of 164%. CCS pays no dividend. The company is next expected to report earnings April 29.

No. 3: First American Financial Corp. (NYSE: FAF)

Based in Santa Ana, Calif., First American Financial is an insurance company. It offers title insurance in the residential and commercial markets. It also offers specialty insurance, which includes property insurance, casualty insurance, and home warranties. When it last reported earnings in February, FAF had an upside EPS surprise of 21% and revenue surprise of 12%. Over the past 60 days, the EPS estimate for the current quarter has increased 41%, while the revenue estimate is up 19%.

Analysts have a one-year target of $68.40 on First American shares, which represent a gain of about 19% from the current price of $57.40. Simply Wall St. suggests a fair value of nearly $124 on FAF stock – a potential gain of about 115%. The trends suggest this company could do far better. FAF also pays a hefty dividend of 3.34%. It next reports earnings on April 22.

No. 4: Tempur Sealy International Inc. (NYSE: TPX)

Tempur Sealy, based in Lexington, Ky., develops and manufactures bedding products that are sold around the world. When it last reported earnings in February, Tempur Sealy had an upside EPS surprise of 29% and a revenue surprise of 7%. Analyst EPS estimates for the current quarter have risen 24% over the past 60 days; sales estimates are up nearly 12%.

Analysts have a one-year price target of $41.38 on Tempur Sealy shares, representing a gain of about 11%. Simply Wall St. has set a fair value of $52.36 on Tempur Sealy shares, a potential gain of 41%. TPX pays a dividend of 0.76%. The next expected earnings date is April 30.

No. 5: Evercore Inc. (NYSE: EVR)

Evercore is an independent investment bank based in New York specializing in mergers, acquisitions, and restructuring. It last reported earnings in February, when the company had an upside EPS surprise of 168% and a revenue surprise of 76%. Analysts have revised the EPS estimate for the current quarter up 44% over the past 60 days. The revenue estimate has increased 21%.

The one-year price target for EVR is $140.50, a 3% gain from the current price of $136.50. Simply Wall St. suggests a fair value for Evercore of $324 per share – a potential gain of more than 135%. EVR pays a dividend of 1.85%. Evercore is next expected to report earnings April 22.

— David Zeiler

Source: Money Morning