Fundamentals

OK, so now you have confirmed the bull market and discovered the industry groups where the big money is flowing.  You’re ready to begin your search for the stocks that will lead you to the profit land!  We start by taking a look at the fundamentals.

In order to drive the long term growth of the stock price, you must have solid fundamentals. Not surprisingly, earnings and sales growth was a characteristic of all of the greatest investing strategies.  Research has shown that earnings growth is the most important factor in determining the potential for a big price move in a stock, but certainly  there are a few other factors that I look for that truly separate the best from the rest.  More on that below.

Earnings

  • While historical earnings growth is important and can often times provide good predictability to future earnings I also place much importance on future earnings estimates.  After all the market is pricing in future expectations of the company ,not its past.  Companies that continue to revise earnings and revenue guidance up will over time outperform.

  • I tend to stick to companies that are growing earnings quarter over quarter by at least 20% for at the very least 3 consecutive quarters.  The longer this trend has been in place, the better.

  • Is growth accelerating?  I pay particular attention to companies where growth is accelerating over at least several quarters.  Is quarter over quarter growth accelerating from 20% to 35% to 80%…… ?  This is a company doing most likely hitting on all cylinders and should be singled out… it could be your next big winner.

NoteI personally don’t feel it’s wise to hold most stocks  through an earnings report.  It’s just not worth the risk.  More often than not, a stock will drop significantly after reporting even though earnings were strong.  This can happen if the company doesn’t give positive guidance for the future or didn’t beat consensus estimates (or better yet, the whisper number).  Even companies that beat estimates and give positive guidance are not immune to post release bashing.  It’s the "buy on the rumor, sell on the news" phenomena.  If companies are expected to report positive earnings, the stock will often times run up prior to earnings and sell off afterwards because the positive earnings were already built into the price.  In fact, there are trading strategies built upon this common occurrence. 

Sales

Along with earnings growth, you want to see solid sales growth.  Strong sales without earnings means profit margins are poor… indicating cost cutting, not organic growth.

  • Basically I look for the same in sales as I do for the earnings.  A history of strong sales is very important, but I pay particular attention to the last few quarters and future estimates.  Is quarter over quarter growth at least 20% over at least the last several quarters?  Is sales growth accelerating?

  • You can fudge the earnings numbers with creative acounting, but you can’t really hide the sales numbers which is why I place more importance on the sales growth.  Big earnings growth with weak sales is a red flag!

Margins

You want to make sure a company is making the most of its sales.  How much profit are they generating from each dollar of sales?

  • Look for pretax profit margins of at least 15% or more (although you may allow for lower margins for certain industries – in this case compare margins of company to industry average)

  • Using the gross profit margin (margin before considering overhead) can give you insight into the compnay’s competitive position.  Competition can lead to price cuts, or worse, price wars.  Declining gross profit margins may indicate the company is facing increasing competition

  • This is a biggie – look for companies increasing their profit margins. 

Return on Equity (ROE)

This number measures how well a company is using its capital which is a good indication of the quality of management.

  • Look for a number greater than 15%, or at the very least above the industry average. 

  • Again, pay close attention to those companies that have been increasing their ROE

Debt

  • Some debt isn’t necessarily a bad thing for a company that is small and growing quickly, but make sure this debt is decreasing quickly as the company grows

  • Pay attention to the industry average.  In some industries, it is fairly common for a company to carry debt.

In a nutshell, single out those companies that are exhibiting accelerating growth, forecasting big growth in future quarters and showing rising margins and ROE.  These companies will be your future big winners.

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