The Other Kind of Momentum

This article was originally published by Zacks.com.

At the end of every year, major publications like The Wall Street Journal produce a list of stocks with the biggest gains.

What do these stocks have in common?

Almost without fail these companies experienced a surge in earnings that greatly surpassed expectations — and the stock subsequently soared. Another term for this surge is positive earnings momentum.

On the flip side, stocks that fell the most during the year experienced negative earnings momentum. To sum it up:

• Good earnings beget more good earnings beget higher share prices

• Bad earnings beget more bad earnings beget lower share prices

As investors, our goal is to line our portfolios with as many stocks experiencing positive earnings momentum as possible. That's because this one element is the key catalyst behind share price momentum.

How do we find more of these stocks?

First we must understand the dynamics of earnings momentum...

Dynamics of Earnings Momentum

Publicly-traded companies are large organisms that include many employees, products, buildings, equipment, etc. When they are experiencing positive earnings momentum, it means that most everything is going right; i.e. a great management team, first rate products and services, happy employees and delighted customers.

These aspects have a self-reinforcing quality that will keep the company headed in the right direction for an extended period of time. The result being a string of earnings reports well above expectations and a booming stock price.

However, the company experiencing negative earnings momentum will behave in the opposite way; a poor management team, inferior products and services, disgruntled employees and dissatisfied customers fleeing to the competition. As you know, this is very bad for corporate profits and thus the stock price.

I like to think of a company as a large freight train stretching as far as the eye can see. When things are going well, the train just keeps rolling down the track. There is a positive rattle and hum to that train that everyone enjoys.

Now imagine the conductor notices that the train is going in the wrong direction. The train is headed south when it needs to go north. Now ask yourself how much time and energy does it take to stop that train? Even worse, how long will it take to back the train up to a spot where it can turn around?

The same is true for a large company that's headed in the wrong direction. Do you think it can be turned around in one quarter? Or two?

History shows that not to be the case. Yet too many of us are content holding onto stocks that have earnings disappointments only to see share prices continue to plummet. I cannot say this emphatically enough...

Sell all companies with negative earnings surprises … IMMEDIATELY!

Steve is the Executive VP in charge of Zacks.com and all of its subscription services.

The information contained in this article should not be construed as investment advice or as a solicitation to buy or sell any stock. Nothing published by Physician’s Money Digest should be considered personalized investment advice. Physician’s Money Digest, its writers and editors, and Intellisphere LLC and its employees are not responsible for errors and/or omissions.