Finding Hidden Winners in the Stock Market
A Harsh Introduction
What do the following two quotes have in common: “The stock market is a legal casino” and “Poker is all luck”? These two statements are often uttered by losers. This might seem harsh, but it’s factual. The stock market and poker have at least one thing in common – they’re both skill games that only the best players win. In both cases, winners are rare. Therefore, it’s likely that at the time you’re reading this, you’re a loser.
Ouch! Don’t be offended. This isn’t meant to aggravate you, but motivate you. Have you ever noticed that professional athletes tend to have their best years after missing out on an All-Star Game or Pro Bowl? That’s because they used that failure it as motivation.
What’s most amazing about investing in equities is that logic is undervalued. Investing is much easier than you think, but before we get to that, please understand that there will be very difficult days. You might own all the right companies, yet your portfolio will drop 25% in one trading day. This can even happen when the market is soaring higher.
On these days, you will crave a shoulder to cry on. You will ask yourself why you ever got involved with stocks in the first place. But if you’re reading this article, then you’re not the type of person to play it safe. You desire excitement, profits, and a higher quality of life. In order to achieve these goals, you must accept risk. While those terrible days will occur, if you stick with high-quality companies — without panicking — you will make a lot of money over the long haul. So the question now becomes: how do you find those high-quality companies?
It’s All About the Revenue
The first thing you want to do is look at a five-year revenue chart for the company that has piqued your interest. YCharts.com is a good place to start. For simplicity purposes, use the well-known Amazon as an example.
At the time of this writing, revenue had increased a massive 274.6% over the past five years. During the same time frame, total expenses equaled 263.1%. Therefore, while revenue was phenomenal, the profit margin is very thin. Furthermore, net income fluctuates and isn’t consistent.
When you invest in a growth stock, you’re going to see much greater potential for stock appreciation than you will with mature, dividend-paying stocks. However, risk will also be much higher.
Look at it this way: on Wall Street, growth is like crack to investors. Investors and traders will crave that crack for months, sometimes years. This drives a stock price higher, and many people become wealthy. In some cases, a growth company is capable of delivering sustainable profits. However, in most cases, that top-line growth doesn’t look so appealing once investors realize that the company isn’t capable of delivering sustainable profitability. When this day comes, investors and traders exit the stock in droves. Those who got out early are considered lucky. Others aren’t as fortunate and must suffer significant losses.
Sticking with Amazon as an example, type in its competitors to draw a comparison chart. These competitors will be Wal-Mart, Best Buy, and eBay. You will notice that Amazon is growing at a much faster pace than its peers. Therefore, if you’re looking for growth, then it’s the type of company you might want to consider. That said, as noted above, investing in these companies is higher risk. For example, Amazon was trading at 1,400 times earnings at one point, which makes the stock extremely expensive. When it missed expectations, the stock sold off in a hurry. You might think that selling prior to quarterly earnings is a good way to avoid this scenario, but that’s not a good long-term approach. You will have to pay more in taxes on gains if you hold for less than one year, earnings could surprise to the upside, and bad news could always come out throughout the quarter and send the stock lower.
The ultimate point here is that companies showing significant top-line growth will offer the most potential in regards to stock appreciation, but this will often come with risk. The good news is that it’s possible to find growth companies trading at much lower multiples (P/E ratios). Those are the hidden winners. Here’s how to find those winners.
Finding Hidden Winners
Go to Yahoo! Finance and type in the ticker symbol for the company that interests you. Then look at the P/E (ttm) ratio in the key metric box that appears on the screen to the left of the daily chart. Do this for your company’s competitors as well.
If you happen to see that the best top-line performer is also trading at the biggest discount, then you might have found a gem. For some reason, the street is undervaluing the company. This could be due to temporary news that drove the stock price down, such as missed expectations for one quarter, poor weather affecting sales, a public relations issue, or something else.Temporary events like weather and public relations issues often present excellent buying opportunities, but in some cases, a public relations issue can turn into a nightmare and lead to sustained weakness. Be careful of these situations. In order to see if it’s a public relations issue or a public relations nightmare, see how long the story lingers and if it leads to a strong response on social media sites. If it does, then this isn’t an opportunity; it’s a warning sign that the company is likely to suffer for several quarters. However, once it’s really beat up, you still might want to take a look at it.
In order to reverse the negative trend for its stock price — related to a public relations nightmare — a company will often choose to make a splash in the news, by either replacing the CEO or announcing layoffs. Both of these events will usually lead to stock appreciation – the former because of renewed hope and direction, and the latter because it will lead to lower costs and improved bottom-line performance.
Assuming that you managed to find a company that’s delivering faster top-line growth than its peers and trading at a discount.,the next step is to see if that company is financially sound.
Financially Sound or Sound the Alarm?
Sticking with Yahoo! Finance, click on Key Statistics, found on the left side of the page (after you type in a ticker symbol.) Look at the Balance Sheet first (toward the bottom on the left.) Continue to use Amazon as an example.
At the time of this writing, Amazon has $12.45 billion in total cash and $3.19 billion in long-term debt. This is good news. But what investors care about most is cash flow. Over the past twelve months, Amazon managed to generate $5.48 billion in operating cash flow. This is strong, especially since the balance sheet is positive.
Of course, Amazon is expensive, trading at 584 times earnings. Therefore, it might not be the hidden winner you seek.
To review up until this point, you want to find a company that’s growing faster than its peers on the top line (revenue), while trading at a lower multiple (P/E ratio), and delivering strong cash flow.
If you find a company that meets the first two requirements (superior top-line growth and a lower multiple than peers) yet its balance sheet is in negative territory, this doesn’t necessarily mean it should be ruled out.
Look at the company’s operating cash flow over the past twelve months. Is it enough for reinvestment in the business and to pay off debt? Wal-Mart is a good example. While Wal-Mart isn’t a growth story, it has a negative balance sheet: $8.74 billion in cash versus $61.82 billion in debt, but it generated a whopping $23 billion in operating cash flow over the past year. That’s phenomenal cash flow generation, allowing Wal-Mart to reinvest in its business (such as smaller-box stores and Canadian expansion), return capital to investors (stock buybacks and dividend payments), and pay off debt. However, Wal-Mart might not be the hidden winner you’re looking for since its top-line growth has slowed over the past decade. It’s looked as more of a dividend investment.
What should scare you is if you see a company with a negative balance sheet and negative operating cash flow. In these cases, it doesn’t matter if the company is growing faster than its peers and/or offering good valuation, getting involved would be risky. Even a positive balance sheet and negative operating cash flow is concerning. The only positive here is that if the company is showing top-line growth and the balance sheet is clean, it could be appealing to larger players. If a company is acquired, then you could see a swift one-day uptick in the stock price. However, investing based on the hopes of an acquisition isn’t recommended and will often lead to more pain than pleasure.
Okay, so you have found a company that demonstrates superior top-line growth to its peers, is appealing from a valuation standpoint, and is financially sound. Good job, but you’re not done yet. There are still a few more requirements for finding the ultimate hidden winner that will greatly increase your odds of finding significant stock appreciation.
Hip or Hop?
If a company is hip, or on-trend, then it’s much more likely to outperform the market. If it’s not on-trend, then you need to hop to another company. At the time of this writing, Under Armour and Michael Kors are on-trend on a company-specific basis.
On a broader scale, the hottest trend right now is the health-conscious consumer. This is why McDonald’s is having a difficult time and Panera Bread is doing well. It’s also important to note that the Millennial generation is the largest generation besides Baby Boomers. Therefore, companies that Millennials favor — Subway (private company), Panera Bread, Chipotle Mexican Grill — are likely to have bright futures.
Another trend is omnichannel. This pertains to retailers catering to consumers by effectively integrating in-store, online, and mobile shopping experiences. For example, you can order online and then pick up an item in the store with ease. This allows customers to shop when, where, and how they want.
Yet another trend is the value-conscious consumer. However, this doesn’t pertain to discount stores as much as in the past. The low-income to middle-income consumer is hurting due to a payroll tax increase (actually the end to a payroll tax holiday), a cut in food stamp funding, and a lack of wage growth. Therefore, the best investment opportunities here are likely to be found with off-price retailers, where middle-income to higher-income consumers shop for steep discounts on quality items.
Time to wrap this baby up
You’re winning company should have superior top-line growth compared to peers, be trading at a better valuation than peers, financially sound, and on-trend. This is all you need to find a winning company, but there are a few other factors to consider.
Don’t invest all your capital in one company. You should strongly consider diversifying your portfolio and dollar-cost averaging. Some investors and traders have become rich by going all-in on one company, but more of them have gone broke. Capital preservation is imperative for long-term success. If you keep going all-in, then you will eventually lose. And that approach isn’t for you, because you’re a winner.