How to Pick the Best Stocks for the Next Quarter

What is the best thing that can happen to a stock you own? A buyout? Sure that gives instant gratification, but there's something even better, and now's the time to identify it.

This article was originally published by Zacks.com.

What is the best thing that can happen to a stock you own?

Many will jump to the conclusion that a buyout is best. Yes, a buyout gives you a whole lot of instant gratification, but I prefer something else.

I love stocks that give me a beat and raise quarter. Those are the stocks that give me monster returns over time … and that buyout opportunity is still present.

What is a “beat and raise”?

With earnings season in full swing, this idea is one that should be somewhat easy to spot. When companies report earnings, there is going to be a vast majority that will generally beat expectations. Of the 104 companies that reported 2Q13 earnings through the end of last week, 72% beat the bottom line expectation.

Then there is the question of guidance. Guidance is given by companies to help analysts and investors understand where the company expects to be over the next 90 days or through the end of the year.

It may shock you to know that 14 companies issued negative guidance. Even more shocking is that only three companies guided higher than what Wall Street was expecting. That is the beat and raise.

Why are there so few?

In researching this article I was very surprised that there were so few companies to raise guidance. Just a precious few are capable of a surprise not only for the most recent quarter, but are going to do even better over the next 90 days.

One of the reasons there are so few companies that produce a beat and raise is that it's hard to do. The implication is that the company has not only done better than expected, but it's about to do it again. Analysts will tend to recognize this type of reporting and then raise future expectations, which prevents the next quarter from being a beat and raise.

An even more powerful idea is that companies want to be conservative when guiding Wall Street. They want to be sure they can beat the number, even if half the sales team calls in sick. They need to be able to fall down and still make the number. The penalty for not beating is severe and it hurts the pocketbook of those who have the most to gain.

What is the benefit?

The earnings beat is a great thing. I see stocks jump 6%, 8%, maybe even 10%, when they top the earnings forecast. Great one-day gains indeed, but stocks that beat and then raise guidance will see even larger gains.

The first thing an analyst will do is re-work the model to bring his or her estimates to the mid-point of guidance at least. This means that before they fully understand the “how” and the “why” of the increase, they bump up the numbers.

As the quarter grinds on, the analyst is able to dig a little deeper. Contact suppliers and customers and work out a deeper understanding of what is really happening. I know this because I did it as an equity research analyst. After some deeper investigation, my estimates might just creep up again to the top of the range.

Those ever higher earnings estimates translate into an even higher stock price. Even better than that is when the market gives the stock a higher multiple. That is the double whammy that the beat and raise can really provide stocks in your portfolio.

Are all beats and raises the same?

The simple answer to that question is no, not at all.

Knowing when a one-time event propelled the company versus a rocket ship that is ready for liftoff can be key. The first step to figuring out the difference is finding the stocks that beat. Then look for the increased guidance.

Finally, find the stocks that were already the recipients of glowing analyst reports, and you are well on your way to finding the top performers for the next quarter.

Brian is the Aggressive Growth Strategist for Zacks.com and provides commentary and recommendations for the Zacks Breakout Growth Trader.

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.