How to Identify a Winning Stock
U.S. EQUITY MARKETS ARE hovering around all-time highs and stocks are trading at stretched valuations. Picking a winning stock has become more of a conundrum than ever before.
In this market environment, the dilemma is whether an investor can pick a winner based solely on a company’s fundamentals or whether they should be more concerned with technical factors.
Take, for example, Adobe Systems (ticker: ADBE), an American multinational computer software company headquartered in San Jose, California. Adobe transformed from a firm selling boxed software to a cloud subscription model with recurring revenue.
An investor who had bought $10,000 worth of Adobe stock back in 1987 would currently have a portfolio worth more than $6 million. Its prospects remain just as high today. The company recently reported a solid earnings estimate revision and prospects are looking bright for both the short and long term.
So what is the best way to identify the next winning stock like Adobe? Historically, an effective strategy for identifying winning stocks has been the CAN SLIM techno-fundamental methodology developed in the 1950s by a stock broker named William O’Neil. This methodology, combined with screening of corporate insider activity, still has the makings for a winning stock-picking formula.
The CAN SLIM methodology incorporates seven traits that help investors identify potential winners that have a product, product line or service innovation that results in earnings acceleration. CAN SLIM is also a good indicator of when investors should purchase a stock before the rest of the market finds out about it and its price takes off.
The acronym CAN SLIM recognizes seven criteria to look for when considering a stock purchase:
- C: Current earnings increasing quarter over quarter.
- A: Annual earnings growth that is increasing year over year.
- N: New product/service/management providing catalyst.
- S: Stock price moves supported with increasing volume.
- L: Leading stock in a leading industry.
- I: Institutional ownership by mutual funds increasing.
- M: Market positively trending.
Adobe serves as a great example of the power of CAN SLIM. Naturally, the only way a company could generate a 600 times return is with rapidly growing earnings and a unique and compelling product or service that is in high demand.
The CAN SLIM methodology that identified Adobe as a “winner” drives the selection criteria for the IBD 50 Index, which has handily beat the S&P 500 since Investor’s Business Daily began tracking it in 2003. The primary driver of the strong performance for the IBD 50 Index is the method by which it seeks to identify growth companies that are likely to be winning stocks, based on earnings, sales, stock performance and other proprietary fundamental and technical factors.
To enhance the CAN SLIM methodology, investors can add an additional screen by keeping a watchful eye on certain-sized insider stock purchases or clusters of executive transactions. There is no one who can know how a company is performing better than its top executives. If the top executive of a company is buying their stock with their own money, it is a great indicator that good things could be in store for investors as well.
Investors can look at the Edgar SEC.gov website, which provides free access to company financial data and more than 21 million filings.
Netflix (NFLX), which was founded in 1997, is an outstanding example of a combination of insider buying and a great CAN SLIM rank that make for all the hall markings of a winning stock. In 2003, Barry McCarthy, the CFO of Netflix, purchased $98,900 worth of stock at $1.64 per share. Today, with Netflix shares trading at nearly $400 per share, McCarthy’s investment is valued at about $23 million. Not a bad return on investment.
Anyone using the CAN SLIM method in combination with an insider-trading screen would have noticed that McCarthy was buying Netflix stock for a few good reasons. First, the company was growing rapidly. Second, Netflix had built a superior service to Blockbuster Video, the incumbent at the time.
The strong signals from these methodologies continue to support Netflix as a buy. Top executives have been buying the company’s stock, and the company continues to grow year-over-year as well as invest in content for future growth potential.
In June, Bank of America Merrill Lynch raised its price target for Netflix shares, predicting the streaming video giant will have a subscriber base of more than 360 million customers by 2030. The firm also gave a buy rating for the stock, citing the strength of Netflix’s original content library, which is expected to bolster the stock’s pricing power.
While picking the next winning stock is not an easy task, the opportunity for investors still exists. CAN SLIM methodology has been a proven system for picking winning stocks. CAN SLIM, combined with keeping a watchful eye on executives’ insider purchase transactions, can bring great financial rewards investors looking for the next winning stock.
5 Basic Techniques For Picking Winning Stocks
We get many questions daily from our clients asking us, “How do you pick a good stock?” We have learned a few things in our 30 years of investing, (41 years if you count the stock we bought at age 11) and we hope to highlight a few of these lessons in several columns over the coming summer. But first, we need to start with some basics. Let’s take a look at five ‘approaches’ to consider when first examining a stock. These are common investment styles, and they all work, but they also need to be highly personal based on your own psychological make up.
Price to Earnings
This is often the first thing investors will look at. It simply shows what a company is trading at in relation to its per-share earnings. Some investors will not buy a stock if this ratio is above a certain level, say 15 times. The problem here: earnings can be manipulated, and can include all sorts of write-downs and/or special charges. A stock with a P/E of 5 times might be ‘cheap’ until you find out there were one-time earnings gains not likely to be repeated. A stock at 35 times earnings might look ‘expensive’ until you find out it took a large write-down which hurt earnings in one particular year. Our advice? Look at P/E ratios for sure, but also look behind the numbers.
Price to Cash Flow
We would consider this an all-around better metric than earnings, for multiple reasons. First, cash flow cannot be manipulated like earnings can be. Second, for dividend investors, cash flow determines whether a company can continue to pay its dividend. Cash flow is also important for companies looking to do acquisitions or buybacks. We would suggest looking at cash flow first, and earnings second. Because of certain accounting methodology, cash flow metrics make comparisons between companies easier as well.
Momentum investors look for positive change. They want to see companies beating earnings estimates, with corresponding price movement and increases in trading volume. We love watching momentum. Companies beating earnings, with rising stock prices and rising volume, really get our hearts racing. If you overlay this with new highs on the stock, even better. The problem with momentum investing? A reversal. High momentum stocks tend to be very expensive, and when momentum fades stocks can get hit very, very hard. It is though, usually a good ride for a while. We suggest watching momentum trends for sure, even if just for new stock ideas.
Price to Book
Value investors love this metric. They look at accounting value, or book value, and compare this to the current price of a stock. On occasion, they can buy a stock for far less than what its ‘true’ value is. It is a decent financial metric, for sure, but there are drawbacks. The biggest problem is determining whether book value is ‘real’. Energy and mining companies, for example, are falling all over themselves taking giant write-downs on assets. This of course lowers book value. It is a good ratio to always consider, though, and investors such as Warren Buffett consider it key.
We could fill this whole paper with lessons on picking stocks through technical analysis. The thesis here is that investors do not even need to care about what a company does, or what sort of announcements it makes, nor what its valuation, cash flow, or debt are. The secret is in reading the charts and interpreting volumes. Technical analysts look at ‘break outs’ where prices move above certain moving averages. Buy signals can be based on volume or hundreds of other indicators. We use technical indicators, but only after we have looked at fundamentals. As confirmation of an investment thesis, they can be very useful. But deciding if a stock is a buy or sell by only looking at a chart still seems a little strange to us.
How to Find Today’s Best Stock
TYPES OF STOCKS TO BUY
Not all stocks are created equal. The reality is that there are actually 11 different industry sectors that qualify stocks. We’ll focus on 2 big ones.
Energy stocks typically have to do with companies that are involved in the oil and gas industry. As you may have guessed, the price of oil is key and has a lot to do with profits in this industry. Beware that stock prices in this industry show high variance and speculation about the price of oil can lead to great profits or massive losses for investors.
This industry is where banks, funds, exchanges and brokerages are categorized. Most of these companies generate steady returns that mirror the general market sentiment. When things are good, these stocks do well – when things are bad, they mitigate the damage.
HOW TO FIND STOCKS TO BUY TODAY
Finding out what stocks to buy always involves a discussion about PE ratio. The price to earnings ratio of a company represents how much investors are willing to pay based on a comany’s profits on a per share basis. To put it simply, imagine a theoretical company that has a share price of $50, with earnings per share of $5. The PE ratio of this company is 10 because the price is 10 times greater than the earnings.
While PE ratio is a versatile measuring tool, it varies by industry and fails to paint a detailed picture of a company’s true situation. PE ratio can vary based on the expectations of a company’s performance and can vary wildly. Use this to your advantage to swoop in when a company’s PE ratio has gone down temporarily, and be wary of stocks with high PE ratios as that necessarily means that prices are going up or profits or going down, or both.
Here’s Some Tips to Find Stocks to Buy
Stick to what you know. If you don’t understand what a company does, don’t buy it. Every stock has an underlying business that is the real indicator of success or failure. If you understand that business, than you will have a greater rate of success.
Beware the bubble. While investors would like to think they are reasonable and make sound investment decisions, this is not always the case. This irrational exuberance can lead to herd behavior where everyone jumps on the bandwagon. Beware the hype and stick to your guns.
HOW TO READ STOCKS
The best way to read stocks is through dividend yield. A dividend is when a company pays out a sum of money to its shareholders. Dividends can be irregular, but most of the time they are paid out quarterly. Dividends are often distributed as a portion of the company’s profits and are typically a safer investment than non-dividend paying stocks.
The dividend yield is pretty simple: take the dividends per share and divide by the price of that share and there you have it. Dividend yield represents how much cash flow one gets for each dollar they invest. A lot of investors prefer stocks with high dividend yield because they pay out cold hard cash.
Dividend yields can be seen almost as an interest rate earned on an investment. The reason dividend yields are so sought after has to with the fact that a company that pays out a steady stream of dividends is often very profitable. The longer the history of these dividends, the better, and more stable the investment becomes.
HOW TO PICK STOCKS
A popular strategy for how to pick stocks is called value investing. The way it works is that investors look to buy companies with high intrinsic value that are trading at a lower price than they should be. In short, they look for solid undervalued stocks and buy them before the rest of the world realizes and the market corrects itself. When the price finally does go up, the value investor makes a nice return and will usually divest from the company in order to re-balance their portfolio as their stock is now worth a lot more than it was before.
Intrinsic value is a tricky thing to estimate. That’s because investors have to estimate what a company is worth and there are no right or wrong answers. The idea is that by using careful evaluation techniques and comparables, a smart investor will be able to figure if companies are undervalued and have a guess as to how much.
One can look at key financial ratios like the PE ratio, but that doesn’t tell the whole story. Financial statements are another great way to check in on the health of a potential value stock, but what does that say about growth or other comparable companies. There’s a lot of work involved, and that’s one way how savvy investors can make money by trading undervalued shares on the stock market.
WHERE TO BUY STOCKS
So you want to buy some stocks, but where do you start? The first thing you will need is to find a stockbroker. Brokers are professionals who are licensed to buy and sell stock from the market on your behalf. As you can probably tell, stockbrokers come in all shapes and sizes depending on your investing needs. They can fill all kinds of different orders and the more expensive ones provide analysis and recommendations.
For the beginner investor, we recommend going for an online or discount broker. That’s because they offer the smallest barrier to entry. With online brokers you can start trading without even meeting someone face to face. All you have to do is call or chat to set up your account and within a few clicks you can start trading. There are tutorials to help you get started but it’s pretty straight forward for the do it yourself type of person.
Discount brokers are a bit different. They are like online brokers but charge a small fee per transaction. While discount brokers are very similar to online brokers, they do provide a small amount of assistance such as company information and other helpful resources. Investors can start at the lower level with discount and online brokers and upgrade to full-service later on. Be prepared to fork over some cash for a full-service broker who will take the time to meet with you and perfect your investing strategy.
How to Find Tomorrow’s Winning Stocks
The holy grail of investing is to find the biggest winning stocks in the market. The outliers. The stocks that break all of the records … i.e., the leaders that go up the most. Studies have been published showing that all of the gains in the market over the decades are from only a handful of stocks. This means that, if your portfolio didn’t have some of these leading stocks, it didn’t outperform the market. Knowing that a few winners are all we need, the following questions arise:
- Do these prior winners share common traits?
- If there are shared attributes, can we systematically find them early?
After all, a portfolio only needs one Tom Brady or Michael Jordan to make all of the difference.
Of course, there are outliers in everything, not only sports. They exist in entertainment, business and investing. I only need to mention Warren Buffett’s name to make my point. Outliers also exist in the stock market. Take a look at the chart of Align Technology, Inc. (ALGN) shown below:
Over my many years of pouring through data, I’ve found that the best stocks out there have three main attributes investors should be aware of: great fundamentals, great technicals and unusual institutional trading activity. Having those three traits combined makes a MAP signal. That’s what you see represented by the green bars in the Align Technology chart above. Each bar is a bullish signal created by combining these three essential qualities. The gray shaded area is the lookback period in our dataset.
The first quality a stock needs to have to be great is a strong grounding in fundamentals. This should be intuitive because, if it’s a good business, shareholders should get rewarded. There are countless fundamental data points out there, but there are two fundamental attributes that consistently reveal themselves in great stocks: growing sales and growing earnings. There is no magical threshold here, but being logical: if a company wins new business year after year while managing its costs, it is likely sitting on a strong foundation. My personal preference is to look for double-digit annual sales and earnings growth.
Below is a snapshot of Align Technology’s earnings and sales growth from March 18, 2016:
The second quality a great stock should have is great technicals over the long term. In plain English, the stock should be trending higher and making new highs. The best companies out there tend to have the best charts as well. As the company performs well fundamentally, the chart will reflect those positives in higher stock prices. For this reason, waiting for pullbacks in market-leading stocks can be tricky, as the best stocks tend to keep climbing year after year, and pullbacks in the shares may not last long at all.
Unusual Institutional Trading Activity
The third and likely most important quality is that a top stock should have continual demand for the shares by big investors. This is what makes the Mapsignals process unique – we specifically look for unusual trading activity in stocks that are likely being accumulated by institutions. We believe that many of the smartest institutional investors in the world can spot the best stocks out there before anyone else, and we want to be along for the ride.
We believe that our method stacks the odds of success in our favor and exploits these footprints over time. We want to spot these signs without having to sit on an institutional trading desk. An easy way to conceptualize how we find these signals is that we try and measure how a stock is trading relative to its price action. We look at many different relationships between volumes and price that can indicate when a position in a stock is being taken.
Our process combines all three of these crucial characteristics needed for tomorrow’s leading stocks into a simple signal. Oh, and the more times the signal appears, the better. Again, it’s all about stacking the odds in your favor.
Below is a zoom-in on Mapsignals’ chart on Align Technology from January 2016 through August 2018:
The Bottom Line
There is an age-old debate about which is a better predictor of future stock price appreciation: fundamentals or technicals. The bottom line here is that the way a stock trades can oftentimes foreshadow the forward fundamental and technical picture more than by looking at financials or a chart alone.