The Biggest Lie About Stocks That You Probably Believe

Before I get into today’s Market360, I just want to sincerely thank the thousands of investors who took the time to attend our Breakthrough Stock Summit last night. In return, I hope they put the quantitative system I showed them to good use in targeting the best buys of 2020. If you didn’t make it, click here to check out the recording, where you’ll also hear my #1 Breakthrough Stock for February.

Since the event generated a TON of interest, I am still fielding questions, and I’d say my most important advice is this:

Successful investing is both simpler and harder than most folks imagine. Harder, in that you’ve got to “stick to your guns” and not be swayed by fear or hype (as the case may be). Simpler, in that there are specific precursors to look for, to maximize your long-term profits…

They just might not be the ones you think!

For example, if you’re like many investors, you learned early on that one of the most important things to know about a stock’s value is the price-to-earnings (aka “P/E”) ratio.

Right now, the earnings side of that equation is looking pretty good. According to FactSet, the S&P 500’s earnings are expected to grow 9.1% in 2020. However, prices are, well, down. I fear that this is going to lead a lot of folks to buy stocks that look like “bargains” – when actually they deserve to be sold.

I don’t say this because I’m bearish on the market. In fact, I’ve been extremely vocal that, however scary the COVID-19 coronavirus may be, stocks won’t stay down for long. By mid-March, the volatility will start to fade, eventually leading to a further run to Dow 40,000.

I simply don’t think that P/E ratios are the best way to find the stocks that will lead the charge.

The truth is, if that’s how you were “brought up” as an investor – you only like to buy cheap stocks with low P/E ratios – you’ve been missing out on a lot of profitable growth opportunities…and you might be saddled with some duds.

But you’re not alone; far from it. For generations, investors have used P/E ratios to determine if a stock is cheap and should be purchased or if it’s expensive and should be sold (or avoided).

Typically, stocks are considered bargains when they sell for P/E ratios of less than 12. Many people think a stock with a P/E of 25 is too expensive. (The long-term average P/E of the broad market is about 16.)

However, if you study the top stock performers of the past 100 years, you’ll see that most mega stock winners trade for more than 25 times earnings during their huge runs. In other words, a slavish devotion to low P/E stocks will cause you to miss out on pretty much every massive stock market winner of the next 100 years.

Why is this the case?

Well, earnings are crucial to a stock’s long-term success, but there’s more to it than that. So, while I agree that “buying the dip” can be a good strategy – I’ll only recommend it if the stock checks a few other boxes first.

Plus, oftentimes you have to pay up to own the best, in both the stock market and in life. There’s a reason why Ferraris cost more than Hondas… and oceanfront property costs more than inland property.

Full disclosure: I’m a big fan of Ferraris, and even own a few of them, but I certainly don’t have anything against Hondas. But the reality is that Ferraris are in a whole different world than Hondas when it comes to quality and performance. That’s why Ferraris are more expensive than Hondas. The very best doesn’t come cheap.

This dynamic is at work in the stock market as well. The stocks of businesses with superior products, superior services, superior sales growth, and superior prospects outperform the stocks of lower-quality businesses. So, investors are willing to afford the higher stock market valuations of the best businesses.

That’s why my Breakthrough Stocks are performing so well – despite the market downturn in the past few weeks.

These are small-cap stocks, which sometimes people worry are “too risky.” But if a stock qualifies as a “Buy” in my Portfolio Grader, it’s actually LESS risky than the broad market (as I explain in this recording of yesterday’s Breakthrough Stocks Summit). Whereas the major indexes are now down 3.5%-7% for the year-to-date, my Breakthrough Stocks are up 5%, on average. My Top 5 Stocks for February are up more like 15%!

In fact, I owe my whole investing career to small-caps like these. After my “failed” experiment in graduate school accidentally demonstrated that it was possible to beat the market, I set to work studying the characteristics of highly successful stocks. Eventually this led me to become one of the first to recommend Google (GOOGL) in my MPT Review newsletter (now Breakthrough Stocks), which in turn led to my nickname in Forbes, “King of the Quants.”

Since then, GOOG is up thousands of percent, and along the way, Breakthrough Stocks has delivered gains like 220% on Bitauto Holdings (BITA), 347% gain on America Movil (AMX) and 457% on HollyFrontier Corp (HFC). All because I found that it’s much, much more important to focus on a stock’s earnings and sales growth than its P/E ratio. So much so that they are key factors in my proprietary stock grading system.

What Really Matters When It Comes to Capturing Triple-Digit Returns

It’s not uncommon to see mega winners trade for 30, 40, and 50 times earnings during their mega runs. I’m talking about massive winners like Netflix (NFLX), Amazon (AMZN) and Facebook (FB), as well as Google.
I could list many more mega winners, but I’m sure you get the idea. The key is that all of these started out as tiny, underestimated small-caps – then soared hundreds of percent. All the while, many investors sat on the sidelines because they felt these stocks were too expensive given the P/E ratio. Those folks just didn’t understand that the very best doesn’t come cheap.

Now this doesn’t mean you should run out and buy any expensive stock. It’s important to keep in mind that a company with a fad product or service can get bid up to absolutely ridiculous valuations — and ultimately burn investors. You don’t want to get swept up in the hype and end up holding the bag in the end. We talked about that in Monday’s article with the brutal decline in First Solar (FSLR), versus the success of one of our Breakthrough StocksEnphase (ENPH).

The two might seem similar, given that they’re both solar stocks. Yet their performance gap just goes to show: Earnings and sales growth are the major drivers of a stock’s price…far more than its sector, and far more than any simplistic measure of its value. The more a company grows its earnings, the more its shares will be worth.

That’s how the market works. And that’s where you should start your search for stocks that can bring you triple-digit returns.

Bottom line: High-quality stocks sporting high P/E ratios scare off the folks who are devoted to buying cheap, lower-quality business… but they reward those of us who understand market history… and know the very best doesn’t come cheap.

Note: While I certainly want to see high scores on fundamental factors like the ones I mentioned here today…I can’t recommend any stock unless it also achieves a high Quantitative Score. That’s the topic of my Breakthrough Stock Summit, where I took the opportunity to discuss what my Quant Score measures – which is something I rarely do publicly – and I even shared my #1 Breakthrough Stock for February.

Tomorrow, I’ll be back with another recommendation in my Breakthrough Stocks Weekly Update. You can get this latest buy “hot off the press” by watching the event replay and giving Breakthrough Stocks a try today.

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