The Story-Numbers-Chart System Puts the Odd of Picking Winning Stocks in Your Favor
OK, so you’ve made the decision to dive into the stock market—you’ve got your account ready and have some rules in place. For instance, you know how much you’re going to invest in each purchase, you know how to set loss limits and you have some general idea about timing the market, so you’re not buying like mad while a bear market takes hold.
But that still leaves out a key ingredient: stock selection! These days, stock ideas can be found on the internet, in magazines, on various TV shows and, when the market is hot, from your neighbors, hairdressers and uncles, too.
But the worthiness of these ideas is usually questionable. Half the time, the pundits on TV or social media, for instance, are simply talking their book (i.e., saying nice things about stocks they own).
So how can you pick stocks that have a good chance to become winners? Interestingly, the best way is by looking backwards!
It turns out that the market’s biggest winners down through the years all had a few similar characteristics, even if they launched their runs decades apart or came from completely different industries. This isn’t magic, but simply a reflection of what most big, growth-oriented institutional investors (who are the ones that really drive these stocks up and, eventually, down) look for when they build big positions in stocks.
We’ve grouped these metrics into three categories: Story, Numbers and Chart. We call it our SNaC approach to finding winners, and it’s been working for us for more than four decades. The key is that winners usually have all three of these categories covered—just one or two doesn’t cut it.
Does this company have a story with no visible ceiling on its growth? That is the most important question we ask when evaluating a stock for purchase—we’re not looking for names that could rise for a few weeks, but for stocks that can grow many-fold if things go right.
Drilling deeper, we determine a firm’s growth potential by asking three questions:
First, does the company offer a new, revolutionary product or service that’s changing the way millions of people work or live? History’s biggest winners usually had something game-changing, like Apple’s iPhone and iPad, Amazon’s e-commerce store, Green Mountain Coffee’s single-cup coffee brewers, Google’s search service, Home Depot’s retail concept, Microsoft’s Office suite for personal computers or even, going way back, Xerox’s copy machine.
Second, do the company’s products target a large mass market? Again, most of history’s big winners have generally served the consumer market (Intel, Google, Priceline, Apple, Green Mountain, XM Satellite Radio, etc.), though if the market is large enough, it can also apply to businesses (Salesforce.com, Cisco, etc.) or a niche consumer market (Gilead, Celgene, Amgen, etc.).
Third, are there barriers to competition? This is very important, as big investors usually hesitate to take huge positions in something that could be an also-ran in a year or two. Whether it’s patent protection (for, say, a medical device or pharmaceutical) or simply a huge first-mover advantage (Home Depot), having some protection from competitors is vital when finding a potential big winner.
Whether it’s retail, technology, consumer products or something else, the best performing stocks all possessed rapid sales and earnings growth for many quarters before their runs. That’s right! Facebook, for instance, had huge growth for a few quarters even as the stock struggled after its IPO. Eventually, of course, it got going and became a flag-bearer of the bull market.
For our part, we like to look for recent sales and earnings growth of at least 20% and, importantly, analyst estimates that tell us that kind of growth will continue for the next year or two. In reality, we prefer far faster growth rates, as most of our own big winners have seen 40%, 50% and even 100% growth rates as they took off.
Also important is to judge the dependability of that growth, a lot of which has to do with barriers to competition (see above). Simply put, big investors will be willing to bid up a modestly growing company (say, 15% to 20% growth) if they think that the growth is likely to continue for many years to come.
What about young companies that don’t have any earnings yet because they’re reinvesting back in their business? If that’s the case, we require very rapid sales growth—usually 50% or more for many quarters. In fact, triple-digit revenue growth has historically been one of our best stock picking criteria.
Many investors will see a great fundamental story and excellent growth numbers and decide to take the plunge. But as we wrote above, it takes all three factors to really put the odds in your favor of finding a winner, and that means having a stock that’s trending higher.
This is probably the hardest factor for most investors to grasp; most want to buy when a stock is well off its highs, the lower the better. But, instead, the biggest winners in history actually came off their launching pad after a prior run higher—they were already under accumulation by the big-money crowd, in other words.
Don’t get us wrong—you still want to look for a lower-risk entry point. We tend to buy stocks that are emerging from multi-month consolidations or stocks that are in clear uptrends, and try to buy them on reasonable dips (two or three weeks, pulling back 4% to 10%, etc.). But the point is that the stock is either just entering or is already in an uptrend—we’re not looking for stocks that are being sold off.
At the very least, you should make sure any stock you’re considering buying is above its long-term 200-day moving average, though we tend to only buy stocks that are also above their 50-day line, telling us the trends are up.
In the market, it’s important to obsess before you enter a trade, not after. Restricting your purchases to stocks that have great stories, top-notch growth numbers and an uptrending chart will increase not just your winning percentage, but also the probability of landing a huge winner. From our experience, it’s those big winners that make all the difference in your long-term results.