In this summary, you will learn
How growth investing works;
How to weigh the fundamental factors growth investors must heed; and
How to construct a sound stock portfolio.
A company’s fundamentals are the most important facts investors need to know.
The crucial fundamental factors are: earnings revisions and surprises; growth in sales, margins or earnings; earnings momentum and return on equity.
Beware of story stocks.
Wall Street is full of hype, pitches and salespeople who take advantage of customers’ cognitive fallibility.
Beware of common Wall Street pitfalls, including juggled numbers, sales pressure and misleading information about earnings and executive options.
Analysts are reluctant to raise earnings estimates, so when they do, it’s a key signal.
Analysts have an incentive to estimate conservatively: if they aim too high and the stock disappoints, they can lose their jobs.
Growth in sales is a certain sign of real growth – but do not ignore margins. Companies that increase sales by sacrificing margins are not good long-term bets.
A portfolio of 60% conservative, 30% “moderately aggressive” and 10% aggressive investments tends to give good returns with relatively low volatility.
Do not fall in love with a stock. Park your emotions outside your portfolio.
Fundamentals are the most critical facts of stock market life, but the relative importance of various fundamentals changes over time. Fundamentals come in and out of fashion. Now and then, a Wall Street advisor will say that one or another fundamental is the solitary key to market success. Indeed, at times, some specific factor may seem to explain everything about the market’s moves. Beware, changing fads mean that today’s fundamental may be tomorrow’s irrelevancy.
“What makes for a great growth stock, one that can grow to five, ten or even 20 times your original investment over time, is the fundamentals of the company.”
The following stock evaluation model tracks eight distinct fundamentals. It screens stocks according to their performance against all of these fundamentals, but the relative importance of each factor may change from time to time. This model focuses on the numbers, and ignores everything else that relates to these fundamental factors:
“By concentrating on the numbers, and just the numbers, we try to take the guesswork out of picking winning stocks.”
1. Upward Earnings Revision – When analysts decide that their previous estimates of a company’s ability to earn were unreasonably low, they revise their estimates upward. Analysts are not willing to make such revisions without very serious reasons. Recent regulations, especially Regulation FD and Sarbanes-Oxley, have deprived analysts of much of their advantage in getting information from companies. Analysts have an incentive to be conservative in their estimates. If they make high estimates and the stock disappoints, they can lose their jobs. If they make low estimates and the stock outperforms their predictions, they still have their jobs. So, a pattern of upward earnings revisions is an impressive sign that a company is growing.
“Analyst revisions have been a part of our models pretty much from the beginning and continue to be one of the more important and powerful parts of my system today.”
2. Earnings Surprises – Reported earnings may be far above or below the consensus estimate; the consensus is conservative and a surprise in either direction is noteworthy. Stock prices depend on what investors expect a company to do in the future, not on what it has done in the past. Analyst estimates tend to resemble each other closely, for reasons that may have more to do with self-preservation than with everyone coming to the same conclusion independently. If everyone is wrong the same way, no one can be singled out for punishment. Curiously, even after an earnings surprise, analysts tend to be very slow to adjust their estimates. Therefore, a surprise in one quarter is apt to recur in another. A company that continually turns in surprisingly high earnings is apt to be rewarded with higher stock prices.
“Herd mentality forces analysts to follow each other and stay close to each other’s estimates.”
3. Growth in Sales – Sales growth is indispensable to corporate growth. Companies that increase their sales are therefore potential growth companies. However, investors should not consider sales growth in isolation because it can happen two ways. Companies can increase sales by selling more of their product or service, or they can raise prices because demand increases even though the quantity sold may not. Or, both could happen.
4. Operating Margins – Sometimes companies can stimulate sales easily by offering discounts or otherwise sacrificing profit margins. Companies that manage to make more money by widening margins while selling the same amount of product, or to maintain healthy margins while selling more goods, certainly have accomplished something that deserves attention. Margins may increase because a company reduces costs. This is good, but cost reduction can only go so far. Margin improvement is better when it occurs because sales volume rises while costs do not. Apple’s iPod sales rose dramatically, but its only real cost increase was in production. Apple’s overhead did not rise appreciably.
“The surest and truest way to measure real growth is to identify whether the company is selling more – and how much more – this year over the prior year.”
5. Free Cash Flow – What really matters is how much money a company makes. Growth in free cash flow is a very important fundamental measure. Free cash flow is the money a company has after paying its debts and operating costs, and making necessary capital investments. Increasing free cash flow matters greatly because without such growth companies cannot expect to be self-financing. Companies with free cash flow can pay dividends, which investors like because they get favorable tax treatment. Companies may also use free cash flow to develop products, buy back stock, expand, or do other things that are good for business and for stockholders.
“Good companies with sound business models and profits can be unduly and harshly punished in the short run even if they are long-term winners.”
6. Earnings Growth – A consistent record of growth in earnings, that is, profits, is a useful measure of success. Although earnings numbers are subject to influence by accounting approaches, do not ignore earnings-per-share (EPS). This useful figure divides a firm’s total profit, minus dividends on preferred stock, by the number of outstanding shares. Stock prices usually rise when firms report growth in earnings per share. Google has been reporting rising earnings since 2005, and its stock has moved up accordingly.
“By focusing on stocks with high alphas and low standard deviation, we can actually have our cake and eat it, too, by getting extra reward with less risk.”
7. Earnings Momentum – This is the rate of growth in earnings. An increase not only in earnings, but also in the rate of growth in earnings, is a powerful performance factor. Growth investors should prefer companies whose earnings are growing more quickly than in the past as opposed to companies whose earnings are slowing. Some investment approaches depend almost exclusively on earnings momentum;
“I want to have some stocks in my portfolio that zig in response to market and economic events, while others zag on the same news.”
8. Return on Equity (ROE) – The ratio of a company’s bottom line to its shareholders’ equity provides a critical measurement of performance. Return on equity is a shorthand expression of the economic results managers are achieving with the stockholders’ capital investment. Returns differ from industry to industry, so investors should compare companies to their industry peers when evaluating ROE performance. Generally, the stronger a company’s position in its industry, the higher its return on equity is likely to be.
Don’t Rely on Stories or Emotions
Wall Street is full of stories. Analysts interview managers, vendors and customers, pour through reams of data and build elaborate models to predict the future performance of a company and its stock. Stories result, and get spread around the investment world. Consider the conglomerates story of the 1960s, the oil story of the 1980s, the new economy story of the 1990s. These stories can be harmful to investment health, even though they are sometimes quite entertaining. Do not invest on the basis of stories. Invest only on the basis of relentlessly disciplined quantitative analysis. “Meaningful, real answers, as opposed to mysterious forces, come from scientific analysis of the numbers underlying a situation.” Numbers are an excellent prophylactic against stories.
“History suggests that optimism is not unfounded. Humans have a long track record of solving their problems and improving their situation.”
Numbers are also, and importantly, a check on emotions. One of the worst mistakes investors make is to use the “gambler’s fallacy,” the mathematical error of believing that just because a coin came up heads several times in succession, it’s somehow due to come up tails; or that because the market has been down for some time, it’s somehow due to rise. Probability doesn’t work like that. Emotion can lead people to buy or sell the wrong security, at the wrong time, for the wrong reason. Falling in love with a stock is a commonplace emotional error. The fact that a stock has been nice to you in the past does not mean it is going to be good in the future. The numbers, and only the numbers, should dictate your investment decisions.
“The stock markets have all the symptoms of your average severe schizophrenic.”
Look Out on Wall Street
Wall Street is a dangerous place. Beware of these pitfalls:
Juggled numbers – Fraudulent financial statements have always been a problem on Wall Street. One of the worst recent accounting practices was so-called pooling-of-interest accounting. This technique let companies give the appearance of growth simply by making acquisitions. WorldCom was one of the worst offenders. The best insurance against becoming a fraud victim is to scrutinize margins, equity return and cash flow. It’s very hard for even a determined fraudster to juggle all three.
Earnings management – Even generally accepted accounting principles (GAAP) give accountants opportunities to project the images they want to project. For example, they may report continuing expenses as one-time charges, or list extraordinary sources of income as ordinary income. Companies may use “slush fund accounting,” holding back some current earnings to make next quarter look better. This misleads investors by giving an inaccurate picture of the timing and stability of a company’s earnings.
Executive options – Many companies give executives stock options as a way of sliding past restrictions on executive salaries. Legislation passed during the Clinton administration denied tax deductibility to salaries greater than $1 million annually, so companies gave execs options instead. Many organizations distorted the incentive of options by backdating them to a time when the stock was low, to assure the bosses of extra money.
Sales pitches – Wall Street is all about selling things. It is a vast machine devoted to selling stocks, bonds, funds and more. Hype makes this machine run. Everyone on Wall Street depends on sales. Recent, highly hyped phenomena include private equity funds and commodity funds. To protect against hype, use only disciplined quantitative analysis.
Alpha and Beta
Beta, a measure of systematic risk, tells investors about a stock’s relationship to the market at large. Specifically, beta indicates in which direction – and by how much – a stock will move when the market moves. Beta is a historic measure, calculated through regression analysis. If a stock moves in lockstep with the market, going up or down 10% when the market goes up or down 10%, its beta is one. If a stock moves two or three times as much as the market, but in the same direction, its beta is two or three. If the stock moves inversely to the market, its beta would be negative. Systematic risk, or beta, is not the only source of risk in the market. Unsystematic risk is measured by alpha. Alpha risk is specific to a particular company.
Author Louis Navellier discovered the power of alpha when he was still a student majoring in mathematics. During a project for Wells Fargo, he was assigned to create a portfolio that would perform exactly as the S&P 500 performed, but his portfolio actually performed better, contrary to all the training he’d received that said the market is unbeatable. He now attempts to construct portfolios that benefit from alpha while eliminating, to the extent possible, market risk as measured by beta.
Alpha is, in a sense, a measure of what really makes a company special. Stocks can have high alpha for two reasons. Higher demand for good stocks can push prices up, or short selling of unsound stock can cause rallies if short-sellers purchase shares after the stock declines. (Short-sellers usually borrow shares and sell them in anticipation of a price decline; after the price decline, they buy the shares back to return them to the lender and lock in their profits.)
Alpha is much discussed but often poorly understood. One error occurs when people calculate alpha by comparing a stock to the wrong index, for example, comparing a small capitalization stock to the S&P 500. Another error occurs when people confuse relative strength with alpha. A stock that tracks a benchmark, but moves farther than the benchmark, does not necessarily have a high alpha. For example, a stock that moves up 20% when the market moves up 10% has a beta of two, but can have an alpha of zero. One method calculates alpha for the duration of a trailing 52-week period, filtering out short-term fluctuations in price; many of the high-alpha stocks identified this way move inversely to the market.
Based on how well a stock measures up on the eight fundamental factors, and based on its alpha, you can use this evaluation model to assign it a fundamental rating and a letter grade (A, B, C, D, E, F). The letter grade reflects the stock’s reward and risk, but the relationship between a stock’s reward and its risk changes over time. For example, Google and eBay were very strong in 2003 and 2004, earned high letter grades, and were seen as conservative investments. Later, however, they carried more risk in relation to reward. In fact, eBay eventually earned an “F” because its price rose to such a point that it was a risky investment. The lesson is that stocks move through a lifecycle. That is one reason why it is so important not to fall in love with a stock.
Investors can base a standard portfolio on 60% conservative investments, 30% “moderately aggressive” investments and 10% aggressive investments. This proportion tends to give reasonably high returns with relatively low volatility. Insulate your portfolio from straightforward market risk by picking stocks that will move in opposite directions and, thus, cancel out market moves.