This Market Leader Just Started A New Growth Spurt

Michael Vodicka's picture

Friday, October 28, 2016 - 11:30am

by Michael Vodicka

Third-quarter earnings season has ushered in an important turning point for the S&P 500.

With more than 25% of the index reporting, earnings are on pace to increase 0.1% from the same period last year. That 0.1% increase doesn't exactly jump off the page. But with S&P 500 earnings declining for five consecutive quarters, a return to earnings growth is a positive signal for U.S. stocks. This reversal back to earnings growth is being led by some of America's most popular brands.

For example, JPMorgan Chase's (NYSE: JPM) per-share earnings of $1.58 beat expectations by 13%. Similarly, Walgreens Boots Alliance's (NYSE: WBA) earnings of $1.07 beat expectations by 8%.

While these reports are both excellent in their own right, one company crushed them both.

In fact, I am calling it the best earnings report of the season, beating expectations by 100%. In the short run, that should help shares outperform the S&P 500 for the rest of the year.

In the long run, this exceptional quarter signals that this market leader still has plenty of growth ahead.

A Massive Positive Earnings Surprise Should Trigger Post-Earnings Drift
Netflix (Nasdaq: NFLX) should be a familiar name. It virtually created the streaming video industry. Today Netflix owns the number-one market share in the United States with 36%, almost triple Amazon's 13% share.

While most S&P 500 companies are struggling to grow revenue and earnings, Netflix delivered powerhouse third-quarter results on October 17.

Earnings of $0.12 per share beat expectations of $0.06 by 100%. The good news sent shares soaring, closing the day with more than a 20% gain and putting the price back within striking distance of the all-time high.

In the short run, Netflix should benefit from post earnings announcement drift (PEAD), the tendency for a stock's cumulative abnormal returns to drift in the direction of an earnings surprise for several weeks (or several months) following an earnings announcement.

The PEAD should help Netflix beat the S&P 500 for the rest of the year.

But more importantly, in the long run, the strong third-quarter results tell me that this market leader still has plenty of growth left in the tank.

Don't Expect Growth To Stop Anytime Soon
Netflix was one of the hottest stocks in the S&P 500 for three years from mid-2012 to mid-2015.

In that time, Netflix was up more than 1,000%. But for the last 15 months, Netflix had been languishing, trading mostly sideways. That weakness was driven by concerns that Netflix's high valuation was being overly optimistic about future sales growth.

However, the companies recent third-quarter results helped calm those worries. Netflix's earnings are expected to surge in the next 18 months.

Full-year 2016 earnings are on pace to grow 28% to $0.40 per share. The 2017 outlook is even more impressive. Earnings are expected to increase 162% to $1.04 per share.

There are only a handful of companies in the S&P 500 with this kind of earnings growth potential.

Netflix is notorious for having a high P/E ratio, even with the significant drops in forward P/E this year. But the strong third quarter is muting concerns about future growth, causing a sharp uptick Netflix's forward P/E ratio from recent lows. 

That makes this one of the best times to invest in Netflix in the last five years.

Risks To Consider: Netflix's higher P/E ratio is a reflection of high expectations for growth. And Netflix has been delivering on those expectations, beating expected earnings by an average of 200% in the past four quarters. But if Netflix falls short of earnings expectations I would expect shares to fall 5% to 10%.

Action To Take: Netflix just delivered one of the best third-quarter earnings report of the season, beating expectations by 100%. In the short run this should help shares outperform the S&P 500 for the rest of the year. In the long run, I believe it signals a new leg higher for shares after languishing for the last 15 months. Buy Netflix anywhere below the all-time high of $135.

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Michael Vodicka does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.