What Makes a Good Story?
Objective Analysis is a Must ...
... But Subjective Analysis Makes the Difference
I tend to be a numbers guy. I’ve always been good at math and science; I actually began my college life as a chemical engineer before bailing sophomore year for the oasis that was a finance major. But even then I came close to getting a minor in math before settling for a minor in economics. (I can tell you that what they taught me about economics in college was all wrong ... but hey, it looked good on the resume.)
Anyway, my point is that numbers have always proven attractive to me; I could always do math easily in my head, and knowing the numbers (whether it was a baseball player’s batting average or our family’s budget) has provided me with a sense of certainty.
Carrying that over to the stock market, I’ve written numerous times about things like triple-digit revenue growth, accelerating earnings growth, expanding profit margins, high relative strength and increasing sponsorship as numbers that correspond to finding winners. I use most of those in various screens to search for the next big thing.
But I learned long ago that it takes a helluva lot more than numbers to really generate big returns. Our founder Carlton Lutts, who himself was an engineer by training, drilled that into my brain when I first started at Cabot. If math was all it took, then computers would rule the market. But they don’t!
So despite what you read about the high-frequency trading geniuses at Goldman Sachs or Morgan Stanley, and despite what you hear about somebody using a “secret formula” to beat the market, a lot of the best results come from good old fashioned research. And that means, instead of relying solely on objective analysis, numbers and math, you also need to do some subjective analysis to uncover huge profits.
This brings me to the title of this Wealth Advisory: What Makes a Good Story? Which is really short for, “What subjective characteristics are the ones that attract big institutional buying, and in turn, produce big stock gains?” Over many decades, Cabot has identified a few characteristics (listed below) that have been found in almost all of our holdings that doubled. Most aren’t surprising, but they can be easy to gloss over—I suggest writing them down on a sheet and using them as a rough checklist when you evaluate a stock to buy.
1. Serves a Mass Market: If a company is selling, say, a $2 million piece of equipment to a few hundred hospitals, its market is somewhat limited, and any hiccup in that small set of potential customers (recession, regulations, whatever) could dent results. Obviously, there are exceptions (Intuitive Surgical comes to mind), but for every one ISRG there have been scores of failures. We prefer companies like XM Satellite Radio, Google, Apple, Crocs, Green Mountain Coffee ... the firms that sell to the consumer market in huge batches.
2. Barriers to Entry: This one is so easy to understand it needs little explanation—if a company has a bunch of competitors chasing it down, odds are good that it will eventually stumble. Yet that doesn’t stop many investors from plowing into some hot chip or software company, two industries that are notorious for seeing the top firms fail every couple of years. Instead, look for a company that dominates its industry through size (Facebook) or the network effect (eBay back in the day) or, our favorite, because it has invented its own industry entirely (XM Satellite Radio). I can tell you that the lack of surety when it comes to competition is one of the top reasons institutional investors refuse to invest big into a stock.
3. Recurring Revenue: This used to be a bigger factor in our stock picking rules; it’s lessened somewhat but is still important. Basically, if you can find a business that gets a steady stream of revenue after making the initial sale, it could be a big winner (and attract institutions, which desire steadiness and growth). And it doesn’t have to be the razor/razor blade model from Gillette; firms like Google (few customers stop advertising with them) and Salesforce.com (very high renewal rates) also fill the bill.
4. Revolutionary Product that’s Changing the Way We Work or Live: This is, by far, the most important of them all. Nearly all of the truly big winners have something new or revolutionary on the market. Xerox’s copy machines were revolutionary. Home Depot’s retail concept was revolutionary. Microsoft’s operating system was revolutionary. Apple’s iPod, iPhone and iPad—all revolutionary! Even Green Mountain’s Keurig single-cup brewers, while simply dealing “only” with coffee, offered an entirely new (and better and easier) way to make a cup of Joe.
As with everything subjective, beauty is in the eye of the beholder—one person might think a product is revolutionary, for instance, while another thinks it’s not. But in general, the more of these categories a company fills, the greater the chance big investors will be attracted to it.
As for the current market environment, it took a turn for the worse on Tuesday, when fears of a military strike on Syria walloped the indexes and most stocks. I wouldn’t get caught up in the reasons for an advance or decline; it’s better to just go with what the market is doing. And by my measures, the intermediate-term trend is now down, which tells me to pare back some and wait for the buyers to return en masse.
That said, all is not lost. First, sentiment has switched pretty quickly; just 38% of newsletters are now bullish, the lowest figure since last November (when the market was in a bottom area). That’s not a reason to be complacent, but it is a good sign.
Second, and more important for my style of investing, growth stocks are acting well; more than a few reached new highs this week and remain in good shape. Of course, if the market continues to skid, many of today’s resilient names will get dragged down for a time, but the fact they’ve held up well this long is a good sign.
My stock pick for today’s Wealth Advisory is Michael Kors (KORS), a stock I’ve recommended in Cabot Market Letter for more than a year. In recent weeks, the stock has broken free from a long consolidation. Moreover, it continues to act well, and it appeared in Cabot Top Ten Trader back on August 12. Here’s what I said in that issue:
“We’ve been waiting months for Michael Kors to decisively get going, and that time has finally come. The stock is now one of the strongest in the market because, after yet another fantastic quarterly report, more big investors are convinced Kors is the next Coach. For the second quarter, sales ramped up 54% (including a huge 27% hike in same-store sales growth) and earnings surged 79%, both trampling expectations. While wholesale revenues remain a big piece of the pie (45% of revenues, growing at a rate of 59%), the retail side of the business has huge global potential. The firm owns and operates 328 stores and concessions today (with another 114 operated by licensing partners), and in the years ahead, it believes there’s room for another 150 in the U.S., 150 in Europe, possibly a couple hundred more in Japan and 400 more smaller shops focused on watches and jewelry! Combine that with the aforementioned huge growth in same-store sales, and it’s likely Kors’ sales and earnings can grow at rapid rates for many quarters to come. All told, Kors has developed into one of the hottest brand names in fashion, and as long as management continues to make the right moves, we think the stock will head higher over time.”
If the market gets hairy, I could see KORS pulling back to 65 or so, which is where it broke out. But so far, it’s shown little desire to go down for more than a few days; the stock is currently just a couple of points shy from all-time highs! I wouldn’t advise jumping in with both feet given the market’s tenuous position, but starting with, say, half your usual amount (dollar-wise) here or on weakness could work, with the idea of buying the rest if/when the market kicks back into gear.
Best of luck,
Analyst, Cabot Marker Letter and
Cabot Top Ten Trader