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How to Identify Stocks with the Best Profit Potential

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The greatest road to wealth is to learn useful facts.” – M.R. Kopmeyer

One of the best things about the stock market is that there’s no such thing as a one-size-fits-all approach. Many different strategies can be successful. There are numerous ways to select profitable companies such as earnings and sales growth, cash flow, return on equity, and low debt-to-equity ratios.

On the other hand, in today’s era it can be quite overwhelming with the amount of data and information constantly pushed upon us. I’ve often found that the more complex an investment strategy is, the less likely it will work in the future.

We want to simplify our process as much as possible while still maintaining an edge, and repeat that process over and over again. The most important skill to learn is how to select the most profitable stocks for your investment portfolio. As history has shown, stock investing builds greater wealth than any other traditional investing method.

A good place to start is to identify which sectors and industry groups are showing relative strength. Technology stocks have led the way during the first year of this new bull market, but other pockets have begun to show renewed strength as the rally has broadened out.

A Simple 3-Step Process to Find Winners

In order to beat the market, we need to own stocks that are outperforming the market. It sounds too simple, but most investors are so caught up with their favorite stocks and fail to separate the wheat from the chaff.

There are hundreds of indicators available to help pick stocks, but a strategy that is easy to learn and has a history of profitability is much more likely to work in actual investing than an overly complicated approach.

Here at Zacks we give you the tools to identify leading stocks and outperform the market. Our Zacks Industry Rank identifies the top industry groups that contain market leaders, providing a tailwind to your investing success. Our Zacks Rank methodology pinpoints stocks that are witnessing positive earnings estimate revision activity, allowing investors to jump on board before an emerging rally gets underway. And our Zacks Style Scores guide investors to the best opportunities, focusing on stocks that show promising earnings and sales growth as well as favorable momentum and valuation characteristics.

Industry Group Association

We can start by detecting leading industry groups. The Zacks Industry Group Rank makes this process easy for investors, classifying industries based on the earnings estimate revisions of the underlying stocks within each industry. If the stocks within a given group are experiencing positive earnings revisions, that industry will receive a higher ranking. Let’s take a look at an example.

The Zacks Manufacturing – Electronics industry is ranked in the top 11% out of approximately 250 industries. Because it is ranked in the top half of all Zacks Ranked Industries, we expect this group to outperform over the next 3 to 6 months. Digging a bit deeper, this industry outperformed over the last year with a 28.3% return.

Quantitative research studies suggest about half of a stock’s future price appreciation is due to its industry grouping. By targeting stocks contained within leading industry groups, we can dramatically improve our odds of success. Also note the favorable characteristics for this group:

Zacks Investment Research

Zacks Investment Research
Image Source: Zacks Investment Research

Rising Earnings Estimates

Positive earnings estimate revisions are at the heart of the Zacks Rank. Our research shows that rising earnings estimates are the most powerful force impacting stock prices. Only the top 20% of all stocks that are experiencing the most substantial revisions are ranked as either a Zacks Rank #1 (Strong Buy) or Zacks Rank #2 (Buy). Let’s build on our example.

Within the Zacks Manufacturing – Electronics industry, Eaton (ETN - Free Report) is a Zacks Rank #2 (Buy) stock. A global technology leader in electrical components and systems, Eaton recently posted Q4 results that beat estimates. Fourth-quarter earnings of $2.55/share marked a 3.24% surprise over the $2.47/share consensus estimate.

Eaton has established a healthy track record of exceeding earnings estimates, delivering a trailing four-quarter average earnings surprise of 4.79%. Consistently beating earnings estimates is a recipe for success.

As we look ahead to the first quarter, the company has witnessed a steady batch of positive earnings estimate revisions as of late. Analysts covering ETN have increased their Q1 EPS estimates by 5.12% in the past 60 days. The Zacks Consensus Estimate is now $2.26/share, reflecting a potential growth rate of 20.2% relative to year-ago period. This is the type of trend we want to look for when narrowing down our list of stocks to include in our portfolio.

Zacks Investment Research
Image Source: Zacks Investment Research

Style Score Ratings

ETN stock has been trending well and showing relative strength. Shares have broken out to an all-time high in sync with the general market. This stock has not only been participating in the uptrend, but has been showing signs of vast outperformance with a nearly 70% return over the past year:

StockCharts
Image Source: StockCharts

Eaton is ranked favorably by our Zacks Style Scores, with a top ‘A’ mark in our Momentum category and a second-best ‘B’ rating in our Growth category. This indicates that ETN is likely to head higher based on a favorable combination of earnings and sales growth as well as powerful momentum.

By focusing on companies that are within leading industry groups, experiencing positive earnings estimate revisions, and that are ranked favorably by our Zacks Style Scores, we can narrow down our list of stocks to those with the best profit potential. Make sure to take advantage of all that Zacks has to offer to uncover top stocks and make 2024 your best year yet.


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