The Curious Investor

This post might be better titled as a guide to buying growth stocks, but it sounds more impressive as a guide to picking earnings beats. It’s my general strategy to timing entry into stocks. My criteria are simple, but this quarter it has yielded tremendous results.  It’s a strategy I believe can work regularly, but admittedly one that I did not employ until this earning season. Hence, why I have waited so long to post on the topic.

One could describe the growth stock cycle in three phases - initial rally, contraction, and discovery.  The initial rally happens as investors in the know find the stock as the company begins its out performance. This could last just a few quarters or for greater than a year, but usually not for longer. The contraction phase happens as the initial investors begin locking in gains. The stock has garnered attention but there remain many skeptics. As a result, the stock will hopefully hold at its new peak price level and trade sideways for several quarters as investors wait for earnings results to come in and support the new valuation. I call this contraction as it marks a phase of P/E contraction, but many experienced investors likely know this as a “base”. Discovery is essentially a base breakout which results from the company’s continued earnings performance and the discovery of the stock by a mass of investors. This is the point that I attempt to enter.

While I don’t classify myself as a growth investor, the strategy tends to yield growth-ier stocks which necessitates a stomach for a bit of added risk. If you’ve been falling the portfolios here at The Curious Investor, you may have noticed several buys that seemed almost clairvoyant this quarter: Mastercard (MA), Google (GOOG), and Apple (AAPL) were the most impressive. Another that could have been truly lucrative had I not been so hesitant would be MEMC Electronic Materials (WFR) and, to a lesser extent, another by along these lines includes Humana (HUM) which beat estimates though without the traditional gap up and rally following.

What do these stocks have in common? An established intermediate term record for earnings beats, projected growth over the next year eclipsing their forward P/E ratios, and internal catalysts supporting guidance. It’s difficult to quantify these qualities for a company, but generally speaking, I subscribe to the belief that forward P/E for a company should be about equal to its projected long-term growth rate. To find companies potentially trading at a discount to their growth rates, I look for year-over-year earnings growth greater than 30%. As an added security measure, I make sure that ROE is greater than 20% to ensure that shareholders are taking part in this profitability.

Next, I like to make sure that this out performance did not begin too long ago. Typically, I try to ensure that there have been no more than four  to six quarters of sustained growth performance. Why is this? Ultimately, companies that beat earnings are hurt by their own success as sell-side analysts begin projecting higher and higher quarterly results. Furthermore, typically, after a year or two of such performance a stock has likely already reached a point where P/E contraction is a must.

Finally, I read annual reports and news articles to find support for the company’s newfound earnings performance. For Apple, it was the launch of a new product as well as product synergies allowing for growth in its classical product markets. For Google, it was simply the continued shift to a net based advertising market as well as potential for continued innovation (gPhone). For Humana and MEMC, the annual reports showed that the companies were participating in dramatic turnaround strategies which the near term earnings performance has proven to be effective and which I believe can be sustained. And, for Mastercard, it was simply a call on the fact that fundamentally the company’s performance had not changed despite a large sell off due to fear in August.

Armed with this information, I look for basing patterns in the company’s stock. For those of you who don’t know what basing patterns traditionally look like, I highly suggest reading the Lessons on Buying at the Investors Business Daily website. IBD will tell you to wait until there is a base breakout, but this is because they don’t tell you to do the extra research that I have described. The goal here is to maximize your return by allowing you the highest possibility of buying a breakout due to earnings performance which is the most regular and dependable catalyst for such an event.

The strategy described here is admittedly rather qualitative. I try my best to be quantitative about my analysis, but in the end it is the catalyst for performance which matters more than any forward looking or backward looking numbers. As a result, there are times when judgment calls have to be made in the interests of keeping a margin of safety. For example, in the case of MEMC Electronic Materials, it was a stock that I identified as a prime candidate for a huge earnings breakout. However, some near term news was a concern to me (a fire at a plant hurting quarterly results). Given that many of these stocks still trade at relatively high P/Es and have valuations which build in higher expectations, a miss during earnings can be catastrophic. Just look at Crocs this quarter. There are times, when it is just better to keep an eye on the stock and wait for the breakout and buy the subsequent rally. Yes, you’ll leave some money on the table, but you’ll keep your own money in your wallet.

In the next few posts, I will try to highlight my individual buys and sells over this last earnings period to help elucidate some of the concepts I’ve described here. Stay tuned!

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