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| The Basics | Spot the next hot sector before it lifts off
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A happy surprise
An earnings surprise is the difference between a companys reported earnings and the consensus forecasts. Its a positive surprise when a firm reports earnings above forecasts and a negative surprise when reported earnings fall short.
All else equal, significant positive surprises usually move stock prices on announcement day, up for a positive surprise and down when earnings come in below forecasts. And positive-surprise stocks often continue to outperform the overall market for several weeks after the announcement date, while negative-surprise stocks typically underperform.
I used two simple screens for last years column: one for finding stocks that are likely to outperform the market (Hot Stocks), the other for finding potentially weak stocks (Cold Stocks).
My Hot Stocks screen required an increase in consensus forecasts during the most recent week and a recent positive earnings surprise of at least 10% (reported earnings of at least 10% above forecasts).
The Cold Stock screen looked for exactly the opposite; a decrease in earnings forecasts over the past week and a 10% or more negative earnings surprise.
My Hot Stock screen listed 165 stocks, while my Cold Stock screen turned up 140 stocks. I sorted each list based on Industry Name and tabulated how many times each industry appeared on each list. I counted Hot Screen listings as positive numbers and Cold Screen listings as negative. For example, an industry scored three if it turned up five times on the hot list and twice on the cold list (5-2).
Industries with scores of three or more qualified for my Hot Industries list and those with scores of minus three or lower made the Cold Industries list. All told, seven industries made the hot list. Four made the cold list.
Last week, I checked the returns for each industrys index, measuring their gains three and six months after I ran my screens on May 5, 2005. Here are the results. For each industry, the table lists the hot/cold score when I ran the screen, along with the returns.
| Hot and cold industries using last years screen | | Hot Industries | Hot/Cold score | Return after 3 months | Return after 6 months | | Oil and gas equipment and services | +7 | 29% | 37% | | Residential construction | +4 | 19% | 4% | | Oil and gas drilling and exploration | +4 | 26% | 33% | | Property and casualty insurance | +3 | 6% | 13% | | Aerospace/defense | +3 | 6% | 3% | | Railroads | +3 | 10% | 20% | | Science and tech instruments | +3 | 11% | 14% | | Average | 15% | 18% |
Cold Industries | Hot/Cold score | Return after 3 months | Return after 6 months | | Gold (mining) | -6 | 12% | 24% | | Paper and paper products | -6 | 2% | -5% | | Savings and loans | -5 | 4% | 0% | | Asset management | -3 | 8% | 23% | | Average | 7% | 11% |
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The hot industries averaged 15% and 18% returns, respectively, for the three- and six-month periods. By contrast, the cold industries recorded 7% and 11% returns for the same periods.
If I restricted the results to the highest-scoring industries (+4 or higher for hot and 4 or lower for cold), the hottest industries returned 25% after three months vs. 6% for the coldest. After six months, the scores were identical: 25% for the hottest vs. 6% for the coldest.
Last week, I ran the screens again with a couple of modifications. This time, I looked for earnings-forecast changes over the past month instead of the one-week time frame I used last year. Expanding the time frame lists more stocks. That, in turn, allows me to confine my lists to stocks with bigger surprises -- specifically, at least 20%, compared to last years 10% requirement.
The parameters for this years Hot Stock Screen are:
Screening Parameter: Earnings Estimate Increased Since
Screening Parameter: Recent Qtr Surprise % >= 22 (Note: I increased this number to get as close to 200 companies as possible.)
The parameters for this year's Cold Stock Screen are:
Screening Parameter: Earnings Estimate Decreased Since
Screening Parameter: Recent Qtr Surprise % <= -20
| Hot and cold industries using my revised screen | | Hot Industries | Hot/Cold score | | Communications equipment | 8 | | Semiconductor equip. & materials | 7 | | Biotechnology | 4 | | Semiconductors (all types) | 4 | | Investment brokerage | 3 | | Lumber, wood production | 3 |
Cold Industries | Hot/Cold score | | Independent oil & gas | -6 | | Medical appliances & equipment | -6 | | Synthetics | -4 | | Broadcasting-Radio | -3 | | Hospitals | -3 | | Internet information providers | -3 | | Wireless communications | -3 |
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I wasnt surprised to see investment-brokerage firms, which have been in the news for reporting blowout earnings, on the hot list. Same thing for communications-equipment makers, which are profiting from the switch to everything broadband.
Also, given the recent drop in energy prices, seeing independent oil and gas firms on the cold list wasnt a shock.
But I was surprised to see semiconductor-equipment makers as well as the chip makers on the hot list. Similarly, I didnt expect to see medical-appliance and equipment makers, Internet-information providers, or wireless-communications suppliers on the cold list. By the way, firms in the synthetics industry make plastics and other chemical products.
A starting point
Even in hot industries, some stocks will buck the trend and go down. Pros making an industry play usually focus on the strongest players in terms of stock-price performance. To pick the best performers, check the Relative Strength figures on the Company Report page. Relative strength measures a stocks performance compared to the overall market. For example, a relative strength of 90 means that the stock outperformed 90% of all stocks over the period measured, so higher is better. The report lists relative strengths for the past three, six and 12 months. Give most weight to the six- and then the three-month figures.
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MSN Money's editorial goal is to provide a forum for personal finance and investment ideas. Our articles, columns, message board posts and other features should not be construed as investment advice, nor does their appearance imply an endorsement by Microsoft of any specific security or trading strategy. An investor's best course of action must be based on individual circumstances.
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