Income Traders Can’t Afford to Ignore This Metric When Picking Stocks

When picking out targets for our covered call portfolio, there are a number of important issues to be aware of. We need to choose an underlying stock that has a strong probability of trading higher, we need to be able to sell call options at an attractive price, and we need to know how to manage the trade moving forward whether it is moving in our favor or against us.

Today, I want to take a look at an important metric for choosing the right stock: analyst expectations, and more importantly, the change in analyst expectations.

Aware of Our Competition

As an investor, you need to know what the professionals think about a particular stock. This doesn’t mean that we always agree with institutional investors. But since their large buy and sell orders are what actually move stock prices, it pays to be aware of their actions.

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Institutional investors are heavily influenced by analyst reports. When I worked on the trading desk of a large hedge fund group, I used to get dozens of emails from analysts every day. In fact, I am still on a number of these email lists, even as a private independent trader.

The good news for you is that you don’t have to be on a hedge fund trading desk to see what analysts expect a company to earn each quarter. Yahoo Finance has a great free tool that allows you to see the average estimates for a particular stock.

Click on this link to see the estimates for Nu Skin Enterprises, (NYSE: NUS), one of the companies I am currently researching. You can change the ticker by using the field above and to the right of the data table.

I use this tool on a daily basis to determine what analysts are expecting a company to do. And this gives me a better understanding of how institutional traders view the stock.

Change Is More Important Than the Actual Reading

One very important thing to note is the recent changes in analyst opinions. You see, when analysts change their expectations for a company, it is typically because new information is coming out.

That new information could be based on a new product the company is launching. It could be due to a change in demand for the company’s services. Or it could be due to a broad shift in the economy.

The key here is that analysts are changing their estimates based on new information. And that new information is very likely to affect how the stock will continue to trade.

If you scroll about halfway down the Yahoo earnings estimates page, you’ll see a section titled “EPS Trends.” I’ve copied a screen shot below for NUS.

This table allows you to see changes to the average estimate, and when those changes occurred. For example, you can see that sometime between 30 and 60 days ago, analysts increased their estimates for this company.

While I don’t consider it necessary to have an increase in analyst expectations, I typically like to buy stocks for covered calls that have an underlying increase in expectations. If analysts are decreasing their expectations, that is a significant red flag and I will need a significant amount of positive data to make up for a decrease in expectations.

A Virtuous Cycle

When considering how high (or low) a stock price can go, you need to look at more than just the analyst expectations. Keep in mind that investors will place a higher or lower value on a stock, depending on their expectations of growth or contraction.

If a company earns $1 per share and has steady growth, an investor might be willing to pay 10 times earnings, or $10 per share. On the other hand, if a company earns the same $1 per share, but is expected to grow earnings by 40% every year for the next several years, investors will likely be willing to pay 40 times earnings, or $40 per share.

Now, think about what happens when analysts increase their earnings expectations and investors increase their growth assumptions.

You might start with a stock that is expected to earn $1 per share next year, and investors are paying $10 for the stock. They expect the stock to grow modestly, but there isn’t too much excitement around the name.

Then, assume the company announces a new product line and analysts increase their expectations to $1.50 per share. At the same time, investors realize that growth will be much stronger, and they are willing to pay 30 times earnings for this stock.

If you run the math, you’ll realize that the stock is now trading at $45 (30 times the estimate of $1.50). This represents a 350% return– even though estimates only increased by 50%.

I refer to this phenomenon as a “virtuous cycle.” It occurs when analyst expectations increase and investors’ growth expectations also increase. With both of these metrics simultaneously working together, stock prices can rally tremendously.

The bottom line here is to be aware of not only the analyst estimates for a stock you are researching, but also to constantly monitor how those assumptions are changing. This is important for us as covered call traders, and is also very important for growth stock investors.

How do you typically analyze stocks you are interested in buying? I would love to hear whether this discussion is helpful in the context of your research process. Please write to Editors@ProfitableTrading.com. I look forward to hearing from you.