Numbers That Blow You Away

An unexpected earnings jump often signals big gains ahead

Earnings season is about to start on Wall Street, and what investors want to see is some happy surprises. These are profits that come in higher than expected. Many companies have been obliging investors: Over the past 10 years, 59% of companies in the Standard & Poor's (MHP ) 500-stock index beat analyst forecasts, according to Thomson Financial (TOC ), a research firm. That number shot up to 69% for the second quarter of this year. Still, "a high percentage of these companies beat only by 1 cents or 2 cents," says David Dropsey, a Thomson analyst. And the post-announcement gains from those minimal surprises are, well, minimal.

The biggest stock-price gains go to the companies whose numbers blow away estimates. That's to be expected. But perhaps more eye-opening is that many of the biggest surprises came from little-known companies. Amerco (UHAL ), FreightCar America (RAIL ), and King Pharmaceuticals (KG ) are hardly household names, but they could be among the superachievers in this reporting season.

Finding these companies ahead of their good news is easier than you may think. "The best predictor of companies that will surprise again are those that surprised in the past," says Russell Lundholm, chairman of the accounting department at the University of Michigan's Ross School of Business. And those that surprise investors in a big way often do so because they are low-profile companies with fewer analysts watching them and making earnings forecasts.

Investing in the big surprisers can be a smart strategy. Lundholm, along with Jeffrey Doyle at the University of Utah and Mark Soliman at Stanford University, studied 160,000 earnings announcements from 1988 to 2000 to measure the stock returns of companies that had large quarterly-earnings surprises. They then constructed a portfolio made up of the top 10% of those with earning surprises. When they bought the companies two days after the earnings announcement and held the stocks for one year, their portfolio beat the market by 9%. When the stocks were held for two years, the portfolio beat the market by a cumulative 15%. Beyond two years, the size of the earnings surprises decrease because more analysts start covering the companies, and the estimates are less wide-ranging.

With his research in mind, we asked Lundholm to screen for the biggest surprisers of the past quarter, figuring they're just at the beginning of a two-year run. We began with all U.S.-based companies that trade on the New York Stock Exchange, the American Stock Exchange, or the NASDAQ. Lundholm screened out stocks with market capitalization of less than $500 million to ensure that the stocks would have some liquidity. That narrowed the list from 5,875 to 1,975. Of those, 651 met expectations precisely -- so he dropped them, too.


Then for each company that beat the consensus of analysts' forecasts, Lundholm calculated the earnings surprise as a percentage of the company's share price. For example, FreightCar America, a Chicago company that manufactures railcars, earned 90 cents per share for the quarter ended June 30, trouncing an expected 29 cents profit. The 61 cents earnings surprise was 3.1% of the company's share price at the end of the quarter.

Lundholm then ranked the companies top to bottom by the earnings surprise as a percentage of stock price. To get the very best, investors can go to the top 10% of companies. In the interest of space, we went to the top 1% of companies. Then we examined each to determine if the strong earnings were sustainable or was the product of a one-time event. So we dropped homebuilder WCI Communities (WCI ), because its surprise was from a real estate sale, and satellite-TV provider EchoStar Communications (DISH ), which got its big boost from a tax credit.

The resulting list is a diverse one, including energy, pharmaceuticals, insurance, management recruiting, and Internet service companies. Among the highlights:

-- Amerco (UHAL ) The company's name is almost generic, but you'll recognize its big brand: U-Haul. Sure, it's a seasonal business, with more people moving in spring and summer. Still, its earnings have some powerful momentum. More specifically, the company, which emerged from bankruptcy in March, 2004, saw a 51 cents earnings surprise for the second quarter of 2005. Operating margins were up 25%, and revenues rose 4%. Improved technology is helping U-Haul get more use out of its fleet, and strong demand is allowing it to increase rental rates. Better marketing has paid off in higher occupancy rates for the company's self-storage unit.

-- King Pharmaceuticals (KG ) A takeover target earlier this year, this maker of branded prescription drugs is starting to look better as a stand-alone enterprise. It turned in a 22 cents surprise for the second quarter. New management is credited with getting inventories under control and with improving the gross margins. Perhaps more important, sales of some products, such as Skelaxin, a muscle relaxant, and Levoxyl, a thyroid-hormone replacement, are proving stronger than expected.

-- Heidrick & Struggles (HSII ). In a strong economy, companies turn to headhunters such as Heidrick & Struggles to fill top positions. That's one reason this executive search firm turned in a 31 cents-a-share earnings surprise in the second quarter. But more important and long-lasting is that the company is finally undertaking a huge cost-cutting effort. That should help raise the firm's historically low operating margins of 7.3%. The company has typically trailed its competitors' margins by up to 4%.

Of course, there are no assurances that Heidrick or any of the others on the short list -- or even those in the top 10% -- will continue to be market-beating stocks. But if you are looking for winners, these give you some good odds.

By Toddi Gutner

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