Earnings: The Indispensable Element Of Great Stocks
Earnings: The Indispensable Element Of Great Stocks
Research shows that earnings growth is the single most important indicator of a
stock's potential to make a big price move. In this lesson, you'll learn how to
find the companies with the best earnings growth and avoid some pitfalls that trick
Why Earnings Growth Is So Crucial
How many times have you kicked yourself for passing up a great stock like financial
technologies or pantaloon retail? There were tell-tale signs that these winners
were about to make major moves before they became household names.
A study of the greatest stock market winners dating back since decade of research
looked at all the biggest stock winners - stocks that doubled, tripled, and even
went up even more. This was a comprehensive study that analyzed every fundamental
and technical variable. What emerged were seven common characteristics among the
big winners with earnings growth being the most significant factor. (The other winning
factors from the study are discussed in subsequent course lessons.)
Three out of four companies had average earnings increases of 70% or more in the
quarter right before they started to make huge price moves.
75% of these top stocks showed at least some positive annual growth rate over the
five years before their major price move.
What Are Earnings?
Earnings, also called net profits or net income, are what a company makes after
paying all its obligations, including taxes. Companies often conclude their quarters
at the end of March, June, September and December, though some companies end their
quarters in different months.
Earning Per Share (EPS) is calculated by dividing the total earnings by the number
of shares outstanding.
Example: XYZ Corp., with 45 million shares, reports net earnings of Rs. 90 million
will have an EPS of Rs. 2.
The EPS is most relevant for investors.
Acceleration Is Also Important
Many stocks that make major advances have another trait. Their earnings accelerate
over the previous three or four quarters. Acceleration represents an increase in
the earnings growth rate quarter over quarter.
Improving bottom-line growth nearly always precedes a burst in stock price. What's
important to realize about this is that it's not just rising earnings that make
a good stock. The key is to focus on companies whose earnings may be drawing professional
investors' attention -- the phase when a stock prepares to spring higher.
(For a detailed description of the importance of volume and institutional sponsorship,
see "Sponsorship: Catching The Stocks The Pros Are Buying.")
So, Here's What You Want To Look For When Researching Your Stocks:
- Quarterly earnings-per-share growth of at least 25% over the same quarter the year
- Preferably, accelerating earnings in the three most recent quarters.
- Annual earnings-per-share gains of at least 25% over the past three years.
Remember 25% is the least you should look for. Ideally higher the better 100%, 200%
or even more. Strong companies with good management teams, innovative products and
leadership in their industries boast the best earnings and reflect the best investing
Unless you have time to sift through endless earnings reports, odds are you'll miss
out on those companies announcing superior earnings. And how do you know the difference
between a one-hit wonder and a potential stock market winner when you are looking
at raw earnings numbers on thousands of companies?
StockAxis.com compares the earnings performance of all the traded stocks on the
National Stock Exchange (NSE) and the Bombay Stock Exchange (BSE) using its proprietary
Earnings Per Share Rating. The EPS Rating measures each stock on a scale of 1 to
99 (99 being best) for a quick assessment. An 80 EPS Rating means that stock is
outperforming 80% of all other stocks based on earnings growth. Seen another way,
a stock with an EPS Rating of 80 is in the top 20% of all stocks in terms of recent
quarterly and annual earnings growth.
Our research shows that the stocks that make powerful gains usually have an EPS
Rating of 85 or higher.
Stocks don't live on strong earnings alone. We use a proprietary Corporate Ratings
System (CRS) which helps us round out for you the stock selection process. This
set of tools also compares other meaningful factors, such as sales growth, return
on equity, profit margins, industry vitality and a stock's price performance.
(Subsequent chapters will go into detail about each of these factors.)
The top 100 stocks that come up in the CRS are then analyzed and the ' top 5 stock
picks ' are presented to you in the market analysis section.
Watching For Pitfalls
Investors can easily be misled by popular myths about earnings.
Myth: You should buy stocks with low price-to-earnings (P-E) ratios.
The P-E ratio is a comparison of the stock's price to its annual earnings per share.
For example, a stock quoted at Rs.50 a share with annual earnings of Rs.5 per share
has a P-E ratio of 10. In other words, the stock is selling at 10 times its annual
Conventional wisdom says stocks with higher P-E ratios are overpriced and should
be avoided. But the truth is that the best stocks often have high — some would say
ridiculous — P-E ratios when they start their big climbs. And they continue having
high P-Es throughout their advances.
Studies prove the percentage gain in earnings per share over the year-earlier period
had a greater impact on a stock's price.
Would you have purchased these "high" P/E stocks?
P/E Ratio before advance
108 (Up 920% in 20 months starting April 2006)
93 (Up 1050% in 23 months starting January 2006)
235 (Up 500% in 24 months starting June 2005)
56 (Up 310% in 12 months starting August 1994)
If you weren't willing to pay the higher P-Es, you eliminated some of the best stocks
of all time.
And believe me the list is long. Have a look at the biggest winners in history,
more often than not they would seem 'overpriced' before their biggest price moves
Key Points to Remember
Sales, Margins & ROE
- Insist on the best earnings performance, not just a promise of earnings. This way,
you will pick stocks with the best probability of making substantial gains.
- Look for companies reporting earnings growth of at least 25% in the most recent
- Find companies with earnings that have accelerated in the three or four most recent
- Identify stocks with annual earnings growth of at least 25% over each of the previous
- Don't overemphasize the price/earnings ratio as a way to compare a company's stock
relative to its earnings.
Key Fundamentals: Sales, Margins, Return On Equity
Sales growth, profit margins and return on equity are vitally important in evaluating
a company's health. This lesson explains the significance of these financial gauges
and how to identify the companies with best numbers.
It All Starts With Sales
Sales figures are a key measure of a company's strength -- or lack of it. Perhaps
no other piece of financial information reflects growth better than sales: the money
that comes into a company from products sold or services rendered. If a company
is run efficiently, sales growth essentially drives earnings growth. Companies basically
have two ways to increase earnings. They either increase sales or reduce expenses
or ideally do both.
When you search for the best stocks, you want a company to have strong sales growth
to support its earnings growth. Think of sales growth as the foundation under your
house: if it is loose, it's not as stable as one with all the structural elements
in place. When you see a company increasing its sales, it's telling you its business
is drawing larger demand and is structurally sound and prepared to expand and generate
the earnings capable of boosting its stock price.
Demand is driven by a number of factors, including larger numbers of customers,
customers increasing their purchase volume, introduction of new products, expansion
into new markets and the improvement of existing products.
The top performing companies show consistent double- or triple-digit sales growth.
It's even better when the percentage growth rate increases quarter after quarter.
Such acceleration is the hallmark of quality growth companies. They reflect a well-managed
How high should sales growth be?
The three most recent quarters should each have strong sales growth of at least
25% compared to their year earlier quarters. Otherwise, sales growth should be accelerating
in the last three consecutive quarters.
Watch For Pitfalls In Sales Figures
Sometimes sales numbers mask problems at companies. Companies may rely on just a
handful of customers, and losing any of them may mean big trouble. Other companies
are overly reliant on overseas markets, putting them at risk of bad economies or
political strife abroad. Also, fluctuations in foreign-exchange rates can seriously
dilute sales figures. Some companies, such as pharmaceuticals, get the bulk of their
sales from a few flagship products. If sales in these items falter, it could mean
more trouble than if the overall sales drop. With retailers, additions of new stores
increase the sales figures, even if sales at existing stores slow down. That's why
retailers report total sales as well as same-store sales, to provide an apples-to-apples
comparison. Another pitfall happens when companies include sales that haven't actually
taken place. Orders that won't be shipped or paid until weeks or months later sometimes
are added to the sales total to inflate results. Also many a times the sales increase
because of the price inflation and not actual demand, typical in commodity companies.
Therefore price increase should be sustainable and not just a one time temporary
Profit Margins: Another Way To Assess Earnings Performance
Profit margins are the portion of a company's sales that end up as earnings. As
an investor, look for companies that generate an increasing percentage of profit
out of every dollar of sales. The larger the margin, the better a company is at
managing and leveraging its business.
Studies of the greatest winning stocks revealed that most showed strong and
even expanding profit margins before they made huge price moves. The
best small and midcap stocks of the 2003-04 period had after-tax profit margins,
on average, of 10% in the two quarters right before they made their main price gains.
For big-capitalization stocks, the margins were 13%. Profit margins can be a major
clue in finding the best stocks to buy, although the numbers vary widely among industries.
For example, retailers tend to have smaller profit margins. Whatever the exact numbers,
a company's margins should be among the best in its industry.
Let's take profit margins one step further. There are two types of profit margins.
One is called the after-tax margin, and it calculates the percentage of earnings
that come from sales after taxes have been paid. Let's take one company that earned
Rs.10 million from Rs.100 million in sales. This gives it a profit margin of 10%.
What if this company had to pay Rs.2 million in taxes? What would that do to the
margin? Well, deduct the Rs.2 million tax payment from the Rs.10 million in earnings
and you've got Rs.8 million in earnings. Divide that by the Rs.100 million in sales,
and the margin is now only 8%. The other type of margin is the pretax profit margin
and it ignores the taxes a company pays. Analysts and investors scrutinize both
numbers. Some prefer pretax margins because they show realistic profitability without
the distortion of varying tax rates.
The rule of thumb for all companies except retailers: seek companies with annual
pretax profit margins of at least 15%. After-tax margins should be at all-time highs
for the company or within 10% of the high.
Of course, increasing profit margins alone don't make for a good investment. You
need to keep an eye on all the key fundamentals, such as earnings growth. Rising
profit margins mean little if sales are dropping, unless there's a change in strategy
and the company drops inefficient product lines, for example. Also, if margins start
trending lower, it could indicate the company is losing ground to competition.
One other note: increasing profit margins aren't the same thing as increasing earnings,
as we've shown with the above examples. Suppose a company earns Rs.10 million from
Rs.100 million in sales, resulting in a 10% profit margin. The next quarter it earns
Rs.10 million from just Rs.80 million in sales, for a 13% margin. You see how a
higher margin doesn't automatically mean bigger profits?
Return On Equity: How Efficient A Company Is With Its Money
ROE is one of the most popular ways to evaluate the financial performance of a growth
company. ROE, sometimes called earnings power, indicates how well a company is being
managed to allow a profit on its shareholder's money. It is also a reliable indicator
of what a company can earn in the future. High ROEs, year after year, tend to reflect
increasing profitability and superior management. Cyclical stocks, those that roughly
move along with the economy, usually show more mediocre ROEs.
You should generally avoid companies with less than 17% return on equity. ROEs vary
among industries, but this is the minimum you should find acceptable. And be sure
to compare a company's ROE against others in the industry to get a realistic comparison.
In most industries, the top-performing companies tend to have ROEs of 20% to 30%.
Occasionally, companies will boast ROEs of 40% or even higher. The higher the percentage,
the more efficient a company is in utilizing its capital.
The best stocks of the 2005-06 period had, on average, an ROE of 20%. For big-capitalization
stocks, the average ROE was 29%.
ROEs have been increasing over the past several decades, largely because high technology
has helped cut costs and boost productivity.
A Quick Way To Weigh Fundamentals
The Sales+Profit Margins+ROE (SMR) Rating -- part of the Corporate Ratings System
(CRS) -- saves you the arduous task of going over the financial reports of every
company and helps you find the best companies in terms of financial performance.
The rating looks at a company's sales growth over the last three quarters, its before-
and after-tax margins and its return on equity. These four fundamental factors are
widely used by analysts.
The SMR Rating ranges from A to E, with "A" being the best and representing the
top 20% of all companies. The "B" stocks are in the next 20% and so on. The "E"
stocks represent the bottom 20% and the lesser-quality companies. The rating also
assigns a greater value to stocks in which any or all of these fundamental factors
are accelerating. Look for stocks with ratings of "A" or "B."
The Launch Pad
OK, let's say you've found a company with great sales growth, profit margins and
return on equity. What's next? As good as these indicators may be, don't ignore
other critical factors, such as a stock's earnings growth (the earnings lesson discusses
how to evaluate earnings.), institutional sponsorship (The amount of buying by mutual
funds and other institutional investors is important and is discussed in the sponsorship
lesson) and relative price strength. (Relative Price Strength Rating takes a stock's
price performance over the past 12 months and compares it to all other stocks. The
rating is expressed on a scale of 1 to 99, with 99 being best. This is covered in
the leaders lesson.) Also, studying a stock chart completes the stock selection
picture. (Charts are explained in detail in the charts lessons.)
Key Points To Remember
- Strong sales growth is one key indicator of a company's success. Quarterly sales
growth should be up at least 25% in the most recent quarter. Otherwise, they should
- Profit margins tell you how much of a company's sales end up as earnings after expenses.
Generally, the higher profit margins, the better.
- Return on equity measures how well a growth company can produce earnings with shareholders'
capital. Look for ROEs of at least 17%.
Catching The Stocks The Pros Are Buying
FIIs, Mutual funds and other professional investors represent the vast majority
of trading activity in the market. As such, they wield tremendous influence on stocks,
capable of sending their favorite stocks up significantly. Here, you'll learn how
to spot the stocks benefiting from "institutional sponsorship."
What Is Institutional Sponsorship?
There's a term on Wall Street everyone soon learns to appreciate: institutional
investors. These are the mutual funds, pension funds, banks and other financial
institutions that do the bulk of stock trading on any given day. It is estimated
institutions account for massive chunk of all trading activity. So when institutions
target a stock for purchase, it's more likely to go up in price thanks to the increased
demand they create. This professional stock buying is called institutional sponsorship.
Institutions make a living buying and selling stocks. They employ analysts, researchers
and other specialists to gather comprehensive information about companies. They
meet with executives, evaluate industry conditions and study the outlook for every
company they plan to invest in.
Tracking What The Institutions Are Trading
Now, wouldn't it be great if you knew exactly which stocks the institutions are
buying and when? Actually, you can.
Although mutual funds and other institutions don't disclose their buys and sells
frequently, you can track their moves by watching for clues in trading activity.
One of the most useful ways to spot current institutional trading is to study volume
percent change figures, in other words, how much trading rose — or declined — in
a day compared to normal. (By normal, we mean the average daily trading volume over
the past 50 trading days.) Because this information is continually updated, it is
the quickest way to detect institutional trading in a stock. When volume spikes
up 50% or more at the same time the stock goes up in price, that's generally a clear
sign that major investors are moving into the stock with both feet. This usually
precedes a significant rise in the stock price. But if a stock's price drops on
heavy volume, it's a sign large investors may be moving out of a stock. If a stock's
trading volume advances but the price goes nowhere, it could mean the stock is reaching
a peak. Information about volume changes can be studied on daily charts.
You can also log on to www.mutualfundsindia.com to see the portfolios and performances
of all the mutual funds.
Fundamentals, Not Just Funds
A stock with strong buying by top-performing institutions has a greater probability
of making you money. But you shouldn't pick a stock on volume, accumulation or sponsorship
numbers alone. First, be sure the company's earnings, sales and other fundamentals
are strong. Other factors, such as the stock's Relative Price Strength, the industry
group's performance and the health of the overall market must be considered, too.
Key Points To Remember
- Institutional investors represent the bulk of trading activity in the market. As
such, their buying and selling power can move a stock's price up or down dramatically.
- You can learn to spot which stocks institutions are buying and selling by watching
for surges in trading volume.
- Look for stocks with an increasing total number of institutional owners in recent
quarters. Look for those stocks that are owned by more funds each quarter.
The Strongest Industries Often Produce The Best Stocks
The Strongest Industries Often Produce The Best Stocks
Research shows that up to half of a stock's move is traced to the strength of its
industry. That's why it's important to track the performance of industry groups.
In this lesson, you'll learn how to do that, plus identify the stocks in the most
attractive industry groups.
The majority of leading stocks are in leading industries. Being in the right industry
group is almost as important as investing in the right company. We lists down for
you a list of top performing industry group in the 'market analysis' section.
Each new market cycle is led by certain industries. In the late 1990s, for example,
telecommunications and Internet-related industries were the leaders. Economic conditions
and trends, in large part, determine which industries and sectors rise to lead the
market. Through much of 1993, generic-drug makers led the market by offering less
expensive medications to a cost-weary pharmaceutical market. In the more recent
market cycle of 2004 construction and realty related industries led the market.
Companies in the top-performing industries usually enjoy strong demand for their
products and services that can drive up their stock's price.
Some Of The Leading Industries In History
Here are a few examples of historically successful industries and the factors that
propelled them to the top. As you can see, economic conditions and trends can play
a huge role in determining which industries lead the market.
Breakthroughs in gene research.
Growth of "anytime, anywhere" communication technology, such as
Demand for high-speed connections.
Watch For A "Follow-On" Effect
Sometimes, a major development happens in one industry and related industries later
reap follow-on benefits. For example, in the late 1960s in America the airline industry
underwent a renaissance with the introduction of jet airplanes. The increase in
air travel a few years later spilled over to the hotel industry, which was more
than happy to expand to meet the rising number of travelers.
But some industries and individual stocks don't ride the leaders' coattails. Don't
assume that just because it's the rainy season umbrella manufacturers will suddenly
surge. You must still look for quality companies capable of producing healthy earnings,
sales, resulting from exceptional products and services.
Check Industry Performance
You don't have to scan every single stock to find out which industries are leading
the market. Each day, StockAxis.com's top industry groups, found in the Market Analysis
section, lists the top 5 industry group out of over 250 different industry groups
by analyzing the price performance of all stocks in each group over the latest six
months. This is a realistic period in which to observe market trends.
Why over 250 industry groups? Because the Indian economy is fragmented, and industries
tend to spawn related businesses that become industries in their own right. Take
the computer sector, for instance. It's not just PC makers. There's also Computer-Graphics,
Computer-Education, Computer-Hardware, Computer-Peripheral Equipment, Computer-Services,
and Computer-Software, which itself is divided into large, medium and small enterprises.
More specific industry classifications make it easier to pinpoint specific areas
leading or falling behind.
Industry Sectors: Another Great Way To Analyze Markets
Reading sector movements helps judge the overall market because different sectors
perk up at different stages of the business cycle. For example, the defensive sector
(This sector includes supermarket chains, utilities, etc., which are sometimes viewed
as havens during market slumps. People don't change their spending much in such
industries even when times are tough.) rises during times of economic weakness or
when investors think the economy is headed down. The high-technology sector has
been strong during expansion phases.
Companies Making New Price Highs
Another excellent way to spot market leadership is look at stocks making new 52-week
price highs located. Look for sectors showing the most stocks making new price highs.
These are usually the leading market sectors.
Key Points To Remember
- Much of a stock's move is due to the strength of its industry. You want to own stocks
in industries that are displaying strength and market leadership.
- Different industries move to market leadership as economic conditions and consumer
trends change. You can identify the new leaders by watching the top five industry
sectors with stocks making the most new price highs.
Leading Stocks Are Leaders For A Reason
The stocks outperforming the market tend to continue performing well, while lagging
stocks are likely to remain underperformers. Here, you'll see why this is an important
lesson for investors and how to identify the leading stocks.
The Best-Performing Stocks Continue Performing Well
How many times have you concluded a stock's best days are behind it, only to watch
it soar as you stand on the sidelines? This assumption has often come back to haunt
investors. In reality, the stocks that are doing best tend to keep doing well, while
those slumping likely will continue to do poorly. Why? The great companies manifest
their strength through superior performance in terms of earnings, sales, profit
margins and, yes, even the performance of their stock.
A study of the greatest stock market winners found that all-star stocks had, on
average, outperformed 87% of the market before they began their most dramatic price
advances. In other words, they were already in leadership positions. This concept
is contrary to the popular bargain-hunting mentality, but is based on historical
How To Find The Leaders
If you want to find next year's winning stocks, look at the better-performing stocks
today. Remember, the biggest winning stocks historically have been, on average,
in the top 13% of stocks at the time they began their major advances. To help you
identify today's leaders, we have developed the Relative Price Strength Rating,
or RS Rating. This rating compares the price performance of each stock over the
last 12 months, with extra emphasis on the three most recent months. Stocks are
rated on a scale of 1 to 99, with 99 representing the top 1% in terms of price movement.
So an RS Rating of 85 means that stock is outperforming 85% of all stocks in terms
of price performance. An RS Rating of 25 means the stock is being outperformed by
75% of the market and should be avoided.
A good starting point for stock selection is identifying the top two or three stocks
with the highest RS Rating in an industry group that's leading the overall market.
Evaluating Potential Leaders
Any stock worth considering should have an RS Rating of 80 or higher. This way,
you're concentrating on the top 20% of price performers. In fact, the most successful
stock selections generally have RS Ratings of 90 or higher just before breaking
out of their first or second base structure.
Any stock below an RS Rating of 70 is not in leadership territory. If you consider
any stock with an RS Rating of less than 70, keep in mind that you're automatically
ruling out the top 30% of the market. It's conceivable these stocks will still go
up, but it's more likely they'll have only lackluster performance. Bottom fishers,
those investors looking for a bargain among down-and-out stocks, are tempted to
buy stocks with low RS Ratings. But history proves the most powerful stocks have
shown prior strength and aren't rebounding from last place.
Many fund managers rely on the Relative Price Strength Rating to help make investment
Another Useful Tool: The Relative Strength Line
It's best when the relative strength line moves up at a sharp angle, showing the
stock is outperforming the market. A line moving down indicates the opposite: a
weakening stock. The relative strength line offers other clues:
- It's a positive sign when the line begins moving higher before the stock price itself
does. A rising line indicates underlying strength in a stock; frequently, it's just
a matter of time until the price itself begins moving higher.
- If a stock's line stays on an uptrend, that's positive. It shows the stock is keeping
ahead of the overall market, acting as a confirmation of the stock's uptrend.
- If a stock's relative strength line fails to follow along with a new high in price,
that's a warning signal. This shows the overall market is moving up faster than
the stock. This may signal the stock is weakening, though the price may not reflect
- RS lines that start drifting lower over a period of time, even if prices remain
steady, indicate the stock is weakening. This also shows the stock is slipping in
comparison with the rest of the market.s
"Sympathy Plays" Don't Play Well
Another common temptation among investors is to seek out stocks that resemble leading
stocks in terms of having similar products or services, but are trading at lower
prices than the leaders. Usually, though, you're better off sticking with the leader
of the industry, even if its share price is higher. Take the IT industry. Wipro
after 2000 crash fell about 90% from the peak of Rs. 1700, the price of the stock
was only about Rs.350 in early 2008 after 8 years of the crash. On the other hand
infosys made a new high and rallied higher sending its stock up during the same
span of time. This is not a rare example, for any industry. The moral: stick with
the leading stocks in a leading industry group.
Rounding Out Stock Selections
No investor should pick stocks based on a single factor. You must weigh the full
picture, including a company's earnings, industry group performance, institutional
sponsorship and chart patterns. (Institutional sponsorship, chart patterns and other
important elements will be explained in detail in subsequent lessons.)
Key Points To Remember
- Relative Price Strength Rating measures a stock's price move over the last 12 months
compared to all other stocks.
- Look for stocks with high Relative Strength. The better-performing stocks tend to
go higher, while the lagging stocks tend to lag even more.
- The Relative Strength line helps confirm a stock's upward price movement. You want
to see the RS line moving in a strong uptrend.
New Price Highs Mean New Opportunities
Many investors have passed up great stocks because they had reached new price highs.
Yet, that's when many of the best stocks begin their major climbs, not when they've
bottomed out. That's why buying bargain-priced stocks is often a frustrating experience.
Buy High, Sell Higher
How many times have you heard the phrase, "buy low, sell high"? This is the conventional
wisdom in the investment world, but research shows you shouldn't be concerned with
that part about buying low. Let's walk through this one step at a time. Research
shows that the best-performing stocks make new highs before they make their major
leaps in price. Moreover, stocks at new highs tend to continue moving higher, while
stocks making new lows tend to continue to move even lower.
This is a concept many investors find difficult to accept. They assume it's too
late to buy a stock that's reached an all-time high. But the great paradox of the
stock market is "What seems too high and risky to most investors is likely to continue
rising. And what seems low and cheap usually goes down."
Just by applying the laws of supply and demand you can see why new highs are important.
When stocks advance, they're demonstrating growing demand as investors raise their
expectations about the company. On the other hand, stocks making new lows are usually
afflicted by just the opposite: sagging expectations. Yes, there's plenty of stocks
in the bargain basement, but they're there because the merchandise, so to speak,
Some stocks may have very strong fundamentals or great stories, yet they don't go
up because there's little investor interest. So while you wait for a stock to be
discovered -- if it ever does -- other stocks are moving into the spotlight.
Stocks reaching new highs tell you professional investors are moving in and pushing
Often, The Best Is Yet To Come
Would you shy away from stocks that more than doubled in the past year or less?
Consider taking a look at what happened with the greatest stocks of every bull market.
They looked overpriced or had already moved or looked risky to buy just before its
biggest move up.
In a good market, opportunities such as these, which start with new price highs,
will surface every two or three weeks. In fact, if you ignore this simple rule,
you would miss out on just about every major winning stock.
However, there can be such a thing as an "overextended" stock: one that truly has
gone up too much, too fast and is likely headed down. As a rule, don't buy any stock
that has risen more than 5% past its buy point. In a nutshell, the buy point is
the price after a stock clears the highest point in its basing formation. Basing
formations are periods of price consolidation when a stock moves more or less sideways
for a number of weeks after earlier advances. The buy point and basing formations
are explained in lesson on charts.
One reason new highs represent better opportunities is because of something market
pros call overhead supply. Suppose a stock that once traded at Rs.50 falls to Rs25.
If it starts making its way back up, investors who bought near Rs.50 start hoping
the stock gets back to the old high so they can sell and break even. This presents
selling pressure near the Rs.50 mark. But once it clears that Rs.50 hurdle, the
stock is no longer burdened by disappointed investors looking to wipe out their
Avoid Cheap Stocks
Perhaps you're one of those investors who think they'll hit the jackpot buying a
low-priced stock that goes on to make huge gains. Some investors equate cheap stocks
with better value or low risk. If a stock costs cheaply priced, then you can't lose
a whole lot, right? Wrong. The truth is that trying to consistently make money with
cheap stocks is difficult, at best. Stocks are cheap for a reason. Think of a stock's
price as a measure of its quality and, consequently, its potential. Stocks selling
cheap have a much smaller chance of making major advances, because they're usually
companies lacking good performance records. Also, professional investors shun low-priced
stocks because they tend to be lightly traded, making it harder to move in and out
of such stocks.
So, you can see what research bears out: it's best to look for new highs in quality
stocks. It's especially good when the stock is coming out of a base. But don't wait
too long: As soon as you spot a buy point -- and if all other factors are in place,
such as good earnings growth -- it's time to have confidence and conviction and
make your move. Otherwise, you may miss your opportunity.
Like you've seen in earlier chapters, you don't want to buy a stock on any single
factor. Where a stock is in relation to its 52-week high and low price is just one
part of your stock-selection checklist. Other important ingredients are the Earnings
Per Share (EPS) Rating, the Relative Price Strength (RS) Rating, the Industry Group
Relative Strength (Group RS), and so on. These concepts are explained in the lessons
on earnings, leaders and industry groups.
Also, be careful with stocks that make new highs on less and less trading volume.
This could be a sign of a stock topping (reaching its peak), especially in cases
when a stock has gone up at least 50% in a few weeks after an extended advance.
When a stock goes up on low volume, it's a gain produced by relatively small purchases.
It's much safer to go with a stock that makes a new price high on higher volume,
which indicates broader support for the stock.
Key Points To Remember
- Quality stocks making new price highs just as they emerge from sound bases on higher
volume are often likely to continue climbing, while stocks making new lows are probably
headed even lower. Therefore, focus on the new price highs list for the best potential
- The great paradox of the stock market is that what seems too high and risky to most
investors is likely to continue rising. And what seems low and cheap usually goes
- You can think of a stock's price as a measure of its quality and, consequently,
its potential. Typically, stocks higher in price reflect higher quality.
New Products Or Management
New Products Or Management
Explosive stock growth doesn't happen in a vacuum. Usually, new products, new services
or new management propels stocks to astounding heights. That's why it's important
to keep up with developments that could launch the next great stock.
The Best Stocks Reflect Success Stories
Stocks don't double, triple or move even higher in a vacuum. There's usually a new
story behind a stock's major price advance. Where would Microsoft be today without
its Windows operating system? If you look through the list of greatest stocks in
U.S., there are plenty of breakthrough products that fueled stock advances:
- Syntex rocketed 450% in six months during 1963, when it began selling the first
oral contraceptive pill.
- McDonald's surged 1,100% from 1967 to 1971 as its low-cost, fast-food franchising
business model swept the nation.
- From 1978 to 1980, Wang Labs' shares grew 1,350% with the development of word-processing
International Game Technology surged 1,600% in 1991-1993 thanks to the development
of game technology based on microprocessors.
- Accustaff rose 1,486% from January 1995 to May 1996 as outsourcing grabbed hold
of Corporate America, sending this temporary-staffing firm to big profits.
- America Online surged 593% from September 1994 to June 1996 as the company rose
to become the leading Internet service provider to a nation eager to log on to the
- Qualcomm rose 376% from February 1999 to December 1999 on the rising popularity
of the company's Code Division Multiple Access technology for wireless telephones.
A study evaluating the greatest stocks dating back to 1953 found 95% of these winners
had breakthrough products, new management or new way of doing business that boosted
these stocks to staggering heights.
It's worth emphasizing that these and other success stories didn't achieve greatness
without proven products.
Often, gullible investors buy stocks because the company promises the cure for cancer
or some other breakthrough technology. It's wiser to wait for products to prove
themselves in the marketplace before investing in something untested. If a product
really hits it big, there will be strong demand for a long time.
For the best companies, success isn't something that happens by accident. They never
stop innovating and evaluating the future of the marketplace. As soon as one product
is out the door, they're working on the next generation and new ways to sustain
their leadership. Microsoft, Google and Apple are one of the greatest examples.
Companies' annual reports occasionally overhype achievements and developments, creating
unrealistic expectations. Whatever annual reports promise should be carefully scrutinized.
Many Internet chat rooms and bulletin boards are notorious for stock hype, too.
Anything you read in these sites needs to be taken with a big grain of salt. You
never know who's posting the information, what their motives are or if details are
even true. Rumors and "tips" are plentiful, though few have any truth to them.
Management Makes Success Happen
"Management is what used to be required to run a company. Today it's leadership.
A manager basically controls, establishes plans, makes a budget, allocates work
and tracks results. A leader is much more focused on vision and beliefs. He or she
inspires people and breaks roadblocks so that people can accomplish more."
-- Robert Eaton, ex co-chairman, DaimlerChrysler.
You've probably heard about super-executives who rescue companies from the brink
of bankruptcy or take them to astonishing heights. Visionaries such as these can
be responsible for a powerful stock move. Apple Computer was faltering in 1997,
when co-founder Steve Jobs returned to lead the company back into profitability.
Under his leadership, Apple shares more than quadrupled over the next couple of
What makes management outstanding? There's more to successful management than inventing
the next personal computer or coming up with the next big trend in fast food. Executives
must also be adept at guiding companies through difficult times, adjusting to changing
market conditions, taking advantage of new opportunities. Good managers are visionaries,
able to redefine business models. Often, other companies emulate their successful
strategies. These leaders demonstrate the ability to deliver on promises, meet growth
projections and deadlines, building a reputation for credibility and integrity.
Communication skills in today's corporate world are vital if managers are to reach
workers at each layer of their organizations.
Key Points To Remember
- A stock that makes big gains often result from new products or services. But be
wary of unproven products, especially if the company management doesn't have a solid
- Superior management is essential to a company's success. That's why sometimes a
change at the top pushes a stock's price higher.