Discipline Means Farewell Apple

 | Oct 26, 2011 | 6:43 AM EDT
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As I advocate repeatedly, one of the strongest predictors of stock price performance is changes in earnings estimates.

The simple reason is that estimate revisions reflect incorrect expectations of future earnings performance of a company. The investor's job is to ferret out situations where a company's actual performance will exceed current market expectations.  This is the only reason the market should pay you for your research. Where the market has correctly assessed a company's earnings performance, the stock will be priced to offer no more than a market return.

A closely-related cousin to estimate revisions are earnings surprises. Clearly, an earnings surprise indicates that expectations were incorrect -- at least on the part of the sell-side analysts that publish on a stock -- and this can be a fruitful starting point for more research. A surprise, combined with your conviction that the upside momentum has longevity and was not a fluke, can lead you into lucrative positions.

I always look closely at true surprises, meaning beats of 20% or more. The usual one- or two-penny beats do not count, as those are hardly surprising. If the surprise is one of a string and my research indicates they are justified and could be sustainable, then a long position may be warranted.

So who has the momentum right now?  I screened through the reported earnings for the last four weeks, and looked for the names with the biggest upside surprises.  The beat had to be better than 20% of the Q3 estimate and the earnings had to be positive. I don't care to look at beats against a loss. The table below shows the leaderboard as of this morning.

Q3 Earnings Surprises

Interestingly, no particular group stands out, which is uncommon. Often, one group such as tech or energy has all the momentum. But in Q3 the beats are all over the place. The very top names are financial services, intriguing considering that the financials are universally hated at the moment as investors purge the group in fear of Euro-default fallout.

I own Discover Financial (DFS). A few consumer names are interesting, such as UnderArmour (UA), GNC (GNC) and Constellation Brands (STZ). Tech is actually surprisingly absent from the list, considering tech is considered to be one of the few groups that can thrive in this weak economy. Most likely, the issue isn't the group's performance but rather that expectations are correct for the group.

The flip side to the surprise list is to avoid the misses. Of course, better to sell before the miss rather than after, but the first miss is rarely the last. (It's classic cockroach theory: there is never just one.) Along these lines, I blew out the Apple (AAPL) shares that I owned since March 2009 that made me a substantial profit. I love Apple the company, I love the products and the stock treated me well. I could debate the merits of the company all day. But the simple discipline that has served me for two decades and led to substantial outperformance is this: only own names with the most rapidly-rising estimates.

A miss in Apple means numbers will be cut, at least in the near term. So, the stock must go. Now, if the estimate trend reverses, I will be the first to buy it back, but for now I must be disciplined. No exceptions, because you never know which exception will be the right one, and which will get you in trouble.

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