A lot of you have been writing in lately, asking if I recommend Facebook (FB) or Google (GOOGL)…now that they’ve finally come down a bit from their lofty highs.
Not a chance.
And I say this as one of the first to recommend Google in 2005, a few months after the IPO, when it met my earnings-growth criteria.
Don’t get me wrong; I certainly recommend buying on dips. But the stock’s got to pass 8 critical tests first. That’s the basis of my Portfolio Grader.
Let me briefly explain those 8 criteria now for anyone looking to avoid trouble in this volatile market.
Imagine this system like a door lock. There are 8 “key pins” inside, and the right key will push all 8 of them upwards…unlocking the door!
But if you insert the wrong key, the 8 pins won’t align correctly, and you’ll never get where you want to go.
When a stock DOES meet these 8 criteria, it becomes an urgent buy inside my system:
- Sales Growth: the percent change in a company’s sales this quarter versus the same quarter last year. Companies that show increasing sales at a very high rate are among the best candidates to become big winners over time. If a company can continually increase sales over long periods of time, then it would seem to indicate that they have a product or service that is very much in demand. I look for companies that show year-over-year sales growth of 20% or more.
- Operating Margin Growth: the profits left after direct costs such as salary and overhead are subtracted. I then look at whether this percentage margin is contracting or growing year-over-year. A company’s operating margin will increase when its product is in such high demand that the company can continue to raise prices for the product or service without an offsetting increase in costs.
- Earnings Growth: the percent increase in a company’s earnings per share (EPS) this quarter versus the same quarter last year. EPS is just the company’s earnings divided by the number of shares they have outstanding. Naturally, companies that are continually growing earnings year-over-year get a higher score than those that aren’t.
- Earnings Momentum: how rapidly a company’s earnings have been accelerating over the past four quarters. Companies that are accelerating and growing earnings faster year-over-year are stronger candidates for my Buy List than those where earnings are slowing.
- Earnings Surprises: a company’s ability to exceed the consensus earnings estimate among Wall Street analysts. Here I am looking for stocks that can exceed what Wall Street believes they can achieve. Stocks that deliver positive surprises for several successive quarterly earnings periods often go on to become growth stock megastars.
- Analyst Earnings Revisions: the magnitude in which earnings projections have increased over the past month. When an estimate is raised, it has tremendous positive implications for a company and its stock. If the expectation is up, then the stock should be worth more — and rise in price to reflect that fact.
- Cash Flow: the money the company has left after paying the cost of doing business and the upkeep and the maintenance needed to stay in business (relative to its total market value). In simple accounting terms, free cash equals operating earnings minus the capital expenditures needed to run the business.
- Return on Equity: a company’s profitability in terms of profits made from the money shareholders have invested. It is calculated by dividing the earnings per share by the equity (book value) per share. The higher the number, the more profitable a company is and the higher return management is providing to shareholders.
Companies that are dominant in their industry tend to earn very large returns on the equity invested.
But determining whether these criteria are met by any given stock – at any given time – well…that’s a lot of numbers to crunch. So, I run Portfolio Grader on my universe of 5,000 stocks every Saturday (to get a full week’s worth of data).
Some of the best buys right now are small-cap stocks. If you want growth – in a market where growth is becoming scarce – then small-caps are just the ticket.
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It’s a tech stock…but NOT Facebook or Google. In fact, you’ve probably never heard of it before. Those have been disappointing investors lately, while this smaller, more specialized company has had a banner year. We’re talking 49% sales growth, 289% earnings growth in the latest quarter. And yes, that’s even better than Wall Street analysts had forecasted!
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