Let’s not have the debate about what the best way to invest might be today. Instead, let’s start here: I love investing in individual stocks.
Oh no! Alert the press!
However, I know that to be a “decent” individual stock investor, you have to “invest” time into making decisions. Those decisions should be less about your gut feelings about companies, and more about reading financial reports as if they were your favorite novel. You also need to read the press about companies, their products and their customers or competitors.
In short, the more you know about a company, the less “gut” you need and the more profitable your trades will be.
In particular, I love some tips that Louis Navellier uses in his book The Little Book That Makes You Money. Rather than just rehash his tips, though, why don’t I put my own spin on them to show you how somebody uses these to create a good portfolio full of great stocks.
The Single Biggest Sign You Own a Great Stock
If you could own only one type of stock, you’ll want one characteristic. What you want, over and above anything, is stock in a company that’ll revise earnings upward consistently. Historically, well-managed companies can keep a lid on expectations about a company. Management works hard to tell investors, “Hey, we might not do very well.” If they’re doing their job right, they’re making financial projections that are conservative, and then killing it on the upside quarter after quarter. Earnings revisions make me giddy. When a company tells me that, “Oh, by the way, we’re going to crush our number this quarter,” most analysts are taken by surprise. In that case, the stock goes through the roof.
The Second Biggest Sign You Own a Great Stock
As if that’s not enough, companies that still manage to surprise with their earnings results are the second most desirable outcome. If you can find a company that not only is consistently revising upward but also that STILL beats the revised numbers, you’re in for a treat. Your stock is headed to the moon.
Sounds Easy, Huh?
Before you hit me with what you’re already thinking, “So how do I find those companies, Joe?”, ask yourself this question: while my first two statements seem logical, ask yourself if you’re currently looking for those two factors when you’re picking stocks. I know it sounds elementary, but ARE YOU DOING IT? If not, it’s time to refocus on those two numbers. In life, we can’t control the output, but only the drivers. We know already that those two drivers above are the numbers that will consistently create value in your pocket. If we can identify those companies, we’re going to win in the investing game.
What Drives Earnings Revisions and Surprises?
To get to earnings revisions and surprises, we need three factors. These three drive most of the surprises we’ll find in the future. Here they are: sales growth, profit margin expansion and free cash flow.
Let’s take them in order:
Sales Growth: If a company is going to consistently win, we can’t get trapped in a spiral of a company cleaning up it’s efficiencies. Sure, efficiency is good, but you can only cut so much workforce and add so much technology to create bigger profits. We need a driver that’s not a dead end after a few months or years. Therefore, we need sales to be expanding. As a former head of Sears once said (just before he was headed out the door), “You can’t shrink your way to greatness.” Sears still needs to hear that message. More sales can be a near never-ending funnel of money to investors. Sadly, sales growth adds costs, which is why we still need to consider the next factor.
Profit margin expansion: Sales growth alone can sometimes create inefficiency. However, if a company is able to expand their profit margin AND increase sales, we’re headed toward unicorn territory. I look at profit margin expansion second after sales growth because I want bigger sales first, then I want to make sure they’re also adding sales efficiently. If so, the chance they’ll surprise on the upside and also revise estimates increases.
Free cash flow: There is no better indicator, in my experience, of a stable company, as there is one that has a healthy free cash flow number. Free cash flow allows companies to make moves in the future that unhealthy companies can’t make. It allows them to weather storms like market or sector downturns. Free cash flow is paramount to a company telling me, on paper, that they’re going to be able to continue their streak.
So, To Wrap It All Up
Buying individual stocks is fun. However, buying individual stocks and crushing it is even better. If you want to crush it with your individual stock picks, look for earnings revisions and earnings surprises. If you see a company raising expectations, dive into the cash flow and balance sheet numbers. You might find the unicorn you’ve been chasing!
Photo: Connie Ma