Why was this stock up 18% on a overall negative day

XRTX: Xyratex Ltd

XRTX was up 18.93 % yesterday. It beats analyst earnings by a wide margin. 14 cents was estimate it came out with 36 cents.Revenue was 246 as against analyst estimate of 239.

This is typically the reaction to earnings surprises. In last one month you would see lot of stocks had similar reaction after their earnings.

Ball and Brown in 1968 first documented the PEAD anomaly. As its name suggests, the PEAD is the tendency of stocks that beat earnings expectations to continue to drift upwards for about two months after the announcement, or likewise for stocks that miss earnings to continue to drift downwards. The market does not immediately fully incorporate the information contained in the earnings announcement in to the stock price.

Earnings are the most important criteria affecting stock prices both in short term as well as in the long term. Investors want to invest in companies that are growing their earnings or are likely to grow their earnings in future. Wall Street is obsessed with earnings and rightfully so. So any earnings related news has a potential to move stocks in either direction. Studies after studies have shown that trading strategies based on post earnings announcement drift (PEAD) has consistently generated abnormal returns.

So when a company announces earnings and it is "surprisingly" good or bad it leads to a rally lasting 2 to 3 months. Earnings EP are easiest to understand and act on. The market reaction tells you whether this earnings was :surprise" and "significant". The stock will immediately go up post such announcement and the move will be supported by high volume. You can create a scan captures such breakout. It should basically looks for a out-sized price move on high volume post earnings. One of the simple way to create a scan like this in Telechart is:

((C - C1) >= 5 AND V > 10000 AND C >= 62.50 AND V > V1) OR ((( 100 * (C - C1) / C1) >= 8 AND V > 3000 AND (100 * V / AVGV100) >= 300) AND C > 1)

So a stock appearing in such a scan has a volume surge and the price surge. We then investigate what caused this price and volume surge or what was "the surprise" that caused such a big move and what is "the nature" of such surprise. Is this information likely to lead to big move. For that we look at :

• Context of the earnings. Is this a first major earnings acceleration.
• What caused this acceleration. Is it one time or likely to persist.
• Does this earnings trend represent a structural change in the industry or the position of this company.
• Is this surprise reflected in current price level.

Market reaction tells you a lot about the likelihood of future prospect of that stock. If volume is very high, you can assume move has legs. You will see that most earnings breakouts which go on to make really big
(like say 100% plus kind of) moves in next 1 to2 months post an earnings will have huge volume surge, typically of 10 times or more compared to average volume. The volume on earnings day might be the highest volume in the history of the stock or multi year high volume.

In earnings breakouts there are two kinds of situations:

1. Stock with no analyst coverage
2. Stock with analyst coverage

Stocks with no analyst coverage are typically smaller companies or companies which are out of favor. On such stocks a significant earnings acceleration compared to last year same quarter as well as quarter over quarter is what to look for. I like to look for companies which had earnings acceleration of 100% plus in such cases. Many of the current market leaders at some stage in their price life cycle such companies. They were neglected small companies which market noticed when they announced big earnings acceleration.

Stocks with analyst earnings coverage are widely followed stocks on the street. Such companies in most cases are well established companies. They have predictable earnings most of the time and analyst keep a very close eye on such companies and constantly adjust their earnings target. But once in a while such companies manage to significantly surprise the market and that results in a earnings breakout. Earnings breakout on companies with significant analyst coverage do not do as well as the first kinds. Genuine analyst surprises are rare and in many cases company pre announce and manage earnings expectations to avoid significant surprise. Established companies also often time secondaries and other capital raising events to time with such surprises and so often you find the EP on such stocks tend to have a pullback.

Earnings Breakouts and low float

This is an ideal combination. In such situation you can have really explosive move. Float below 25 million is ideal for this. The best moves happen on float below 10 million. Earnings breakouts on companies with 100 million plus float tend to have pullbacks. Earnings breakout on stock with 500 million plus float is something which I not really very enthusiastic about unless they are trading near their historic lows or are in single digits.

Guideline for finding good earnings breakouts:

• 100% plus EPS+100% plus sales+ first or second earnings acceleration+float below 25 million+prior neglect+no analyst coverage. Best combination
• 40% plus EPS+ IPO of less than a year. Second best combination.
• 100% plus earnings surprise+below 100 million float+ one month price growth below 5%+first earnings surprise. Third best combination.
• Retailer+price within 25% of 52 week low+earnings surprise of 25% plus+float below 100 million. Fourth best combination.

Related PostsHow To Trade Earnings
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