One of my oldest trading rules is simple: Never underestimate a big, mega-cap stock that gaps strongly higher following its quarterly report. I learned this lesson long ago when I watched a few blue chip names gap up and I passed on the trade, telling myself “they’re too big to make much of a move after the gap.” Well, that is true to an extent—a Dow Industrials stock isn’t going to double or triple after it gaps up on earnings. But I’ve seen for many years how these stodgy stocks change character following an earnings gap, rising solidly for the next two to six months, often with few pullbacks along the way.
The reason these mega-cap gappers work so well is easy to understand. The gap itself (which should be at least 6% or 7%, pushing the stock to new highs) is a sign of a major improvement in perception—all the institutional investors and analysts have seen the latest numbers and dissected management’s conference call, and, in effect, are voting that much better times are ahead. And because these stocks are so big and well-traded, it’s easy for huge mutual, pension and hedge funds to buy large quantities of stock.
This has played out a couple of times already this year. Starbucks (SBUX) gapped up 7% on nearly four times normal volume followings its earnings report in January. Even in a flat market year that hasn’t been great for growth stocks, you can see how shares have marched more than 20% higher during the past few months with almost no meaningful pullbacks along the way.
Walt Disney (DIS) is about as blue-chip as it gets, but since its 8%, four times average volume gap in early February, the stock has risen about 18%. Again, notice how all pullbacks have been tame along the way, generally contained by the 50-day moving average (blue line). In other words, it hasn’t been hard to hold onto the stock.
And just last week, there was another mega-cap stock that gapped higher, one that I think can also march steadily higher in the weeks ahead. Google (GOOGL) soared out of a long 16-month base as earnings topped estimates and the company provided some added color to its results (including bullish data from mobile search ads and its YouTube subsidiary). All in all, the stock rallied 16% on a whopping seven times average volume.
Sure, it’s always possible GOOGL fails, but my experience is that seven or eight out of 10 of these trades work—and when they don’t, you can usually limit your loss to just 7% or 8%, while the winning trades run for two or three times that. The stock looks buyable to me, and while it won’t make you rich, GOOGL (and other mega-cap winners that lift-off soon after earnings) should provide solid upside.