The S&P 500 is up 2.7% in the month since the close of the third quarter, and has boomed 15% so far this year. That upside strength, especially as companies report their third-quarter results, is hiding a growing deviation in the market. 

Behind the optimism for tax cuts and economic growth, this trend has grown from investor fears of stock valuations.

And while the overall market trend to higher prices makes for shaky investments in what could ultimately end badly, this new trend is actually creating an opportunity to invest in solid companies with catalysts for upside growth.

I’ve been mining the market to pick winners out of the third quarter’s losers — and they could be some of the best investments I make all year.

#-ad_banner-#​Complacent Investors Are Too Quick To Punish
As of November 3, 81% of companies in the S&P 500 have reported third quarter earnings. Two-thirds (66%) have reported positive sales surprises and three-quarters (74%) have reported positive earnings surprises on a blended growth rate of 5.9% over the same quarter last year.

That market strength fades quickly if you strip away some of the best-performing sectors. Exclude the energy sector and year-over-year earnings growth drops to 3.7% for the index. Remove the largest contributor, Information Technology, and average earnings growth is just 2.7% versus 11.9% growth in profits reported over the first half of the year.

Insatiable investors are not ready to question the market’s uptrend just yet. Any earnings growth above expectations, even if the company routinely beats, is enough to support prices.

But one trend is developing to show exactly how nervous investors are becoming.

On valuations that were already stretched going into earnings, the market isn’t rewarding companies that report earnings above expectations. Companies that have reported positive earnings surprises have seen an average price increase of just 0.3% two days before the earnings release through two days after the report. That’s well below the five-year average of 1.2% for positive earnings surprises. 

On the contrary, companies that have missed earnings expectations have seen shares slide by an average of 3.6% over the four-day earnings window. That’s larger than the five-year average of 2.4% for negative earnings surprises.

So it seems that, while investors are not yet ready to question the outlook for all stocks, they may be panic-selling out of stocks that miss the market’s high expectations.

Picking Up The Pieces Of Fallen Stocks
The punishment in shares of companies missing expectations has opened a rare opportunity for value in an otherwise expensive market. Investors have fled any company with the slightest change in sentiment, even on catalysts for upside growth.  

Mattel (Nasdaq: MAT) is down 15% from its October 26 report when it missed earnings expectations by 84%, hindered by the recent bankruptcy at Toys R Us. The company has been hit by a perfect storm of lower licensing income, higher royalty expenses, and unfavorable product mix that has sent its operating margin plunging to 3.4% in the trailing quarters versus 9.5% last year.

Despite recent struggles, Mattel still controls roughly 15% of the domestic toy market and has the financial size to secure profitable licensing deals. It owns some of the most valuable toy brands, including Barbie, Hot Wheels and Fisher-Price. Shares trade for just 0.9 times sales, a discount of 53% against its five-year average multiple of 1.9 times sales. 

Management outlined an ambitious turnaround strategy in June and has brought on four new executive-level positions, including a new CFO in October. Sentiment is very low on the shares but any turnaround in margins could quickly drive earnings and bring investors back.

Cybersecurity firm FireEye (Nasdaq: FEYE) saw its shares slide 11% even as the company reported a slight beat on earnings — but not the larger surprise for which investors were waiting. The company had beaten expectations by 63% on average over the last four quarters, so beating by just $0.03 sent the shares down sharply. 

Investors have punished any tech company not beating expectations. The sector has reported the second-highest earnings surprise, 11.7% above expectations on average, of the 11 sectors tracked by FactSet.

FireEye leadership reported the company’s average contract length dropped to 25 months from 27 months reported last year and that it may drop as low as 20 months next year. Investors are worried that the company is losing its grip on customer loyalty, but FireEye is still a leader in cybersecurity through products and services.

Growth in demand for cybersecurity solutions could help the company beat expectations for sales growth of 6% over the coming four quarters. Shares are trading for 3.5 times sales against an industry average of 6.0. The company has a solid balance sheet with $879 million in cash and just $770 million in debt.

General Electric (NYSE: GE) is down 16.3% since its October 20 report after missing expectations by 41% on weakness in its power generation and industrial segments. The miss was a wake-up for management, which unveiled sweeping changes to take place over the next two years.

The company is targeting more than $20 billion in asset sales and over $2 billion in cost savings. Activist investor Trian Partners has already taken a board seat in October to drive change. Shares are trading at 1.4 times sales, a 26% discount to the average multiple of 1.9 times sales over the last five years. While some analysts are questioning the safety of the dividend, I see the cost cutting and asset sales as ultimately protective of the 4.5% rate investors will enjoy while the shares rebound.

Risks To Consider: While they are a better value at these levels, even these three names are susceptible to larger market selloffs and weakening investor sentiment.

Action To Take: Take advantage of short-term selloffs as the market punishes companies for missing expectations to find rare value in this market. The three stocks mentioned here should be a good starting point for research, but there may be more opportunities to be found.

Editor’s Note: You know how in sports, some players unintentionally signal what they’re about to do next. Like when a pitcher accidentally lets a batter see his grip on the ball before he throws it. Well this kind of “tell” doesn’t only happen in sports… but in the stock market too! And if you can spot this subtle sign… you’ll know exactly what a stock will do… before it makes its move. Here’s how you can spot it too.