Trade Like a Stock Market Wizard: How to Achieve Super Performance in Stocks in Any Market: How to Achieve Superperformance in Stocks in Any Market

by Mark Minervini

A company that is taking market share in a slow-growth industry can also grow its earnings quite nicely. What’s most important is that the company can make substantial profits. A good balance sheet, expanding margins, high return on equity, and reasonable debt are all signs of good management. Some market leaders grow earnings at a very healthy rate for extended periods in industries with percentage growth rates in the low to mid-single digits. However, a company that is taking market share or has a large portion of market share in a fast-growing industry can increase its earnings at a meteoric pace.

Market leaders are capable of producing huge price appreciation during their high-growth phase. They generally grow earnings at a rate of 20 percent or higher. Many average 35 to 45 percent during their best 5- or 10-year stretch.

Here’s the beauty about ultrafast growers: these companies grow so fast that Wall Street can’t value them very accurately. This can leave a stock inefficiently priced, providing a big opportunity. As long as a company can sustain significantly expanding sales and earnings, the stock price will follow—maybe not immediately, but stock prices do follow earnings growth over time. The faster a company can grow earnings, the more likely it is that its stock price will follow.

A category killer is a company whose brand and market position are so strong that it would be difficult to compete against it even if you had unlimited capital.

When a firm produces a successful formula in one store and then replicates it over and over—in malls and in locations around the country or around the world—it’s a cookie cutter. Think of McDonald’s, Walmart, Starbucks, Taco Bell, The Gap, Home Depot, Chili’s, Cracker Barrel, The Limited, Dick’s Sporting Goods, Wendy’s, Outback Steakhouse, and Costco Wholesale, which are great examples of successful rollouts of the cookie cutter concept.

You want to see same-store sales increasing each quarter. High-single-digit to moderate-double-digit same-store sales growth is high enough to be considered robust but not so high that it’s unsustainable (25 to 30 percent or more same-store sales growth is definitely unsustainable over the long term). In general, same-store sales growth of 10 percent or more is considered healthy.

Always track the top two or three stocks in an industry group.

You should concentrate on the top two or three stocks in a group: the leaders in terms of earnings, sales, margins, and relative price strength. This is especially true if the industry group is a leading sector during a bull market.

Institutional favorites are also referred to as quality companies or official growth stocks, but don’t let those titles impress you too much. These are mature companies, and they’re certainly no secret. They generally have a good track record of consistent sales and dividend growth, and they often attract conservative institutional capital because of their proven history of management’s ability to increase earnings, expand margins, and create shareholder value. Their earnings growth is generally in the low to middle teens. These companies are regarded as the ones that most likely won’t go out of business. Often they are referred to as blue chips or stalwarts. Examples include Coca-Cola, Johnson & Johnson, and General Electric, to name a few. Although all that sounds good, there’s one problem: they’re usually big and sluggish by the time they reach institutional favorite status. Although their earnings are deemed to be consistent and of high quality, usually the growth is slow, and the companies are so widely followed that there’s little room for rapid price appreciation.

In purchasing a turnaround situation, you should look for companies that have very strong results in the most recent two or three quarters. You should see at least two quarters of strong earnings increases or one quarter that is up enough to move the trailing 12-month earnings per share to near or above its old peak. In looking at turnarounds, ask yourself: Are profit margins recovering, and are they at or close to the peak? Are the results based only on cost cutting? What is the company doing to increase earnings beyond cost cutting, productivity enhancements, and shedding losing operations? How much cash does the company have? Although a company can burn its cash, you can try to assess the burn rate and debt load to get an idea of how long it can last while running in the red.

Is the stock acting well in market? and Are the fundamentals coming in strong? You want to see both. Turnaround stocks are up against relatively easy comparisons from earlier quarters, and so it’s important to see the most recent results up significantly: generally 100 percent growth or more in the most recent two or three quarters and a dramatic acceleration versus the past growth rate.

Buying a cyclical after several years of record earnings and when the P/E ratio has hit a low point is a proven method for losing half your money in a short period of time.

Interestingly, cyclical stocks have an inverse P/E cycle, meaning they generally have a high P/E ratio when they are poised to rally and a low P/E near the end of their cycle. This is due to the fact that Wall Street analysts try to anticipate the earnings-cycle dynamics of these companies, which are dependent on the business cycle. Growth investors may become confused when they attempt to apply an earnings model to the selection process for cyclical stocks, and their stock picks do not respond like a cookie cutter retailer or a high-growth technology company poised for many continued quarters or even years of growth after earnings are already on the table.

With cyclical stocks, the trick is to figure out whether the next cycle turn is going to happen earlier or later than usual. Inventories and supply and demand are important variables in analyzing the dynamics of cyclical stocks. When the P/E ratios of cyclical stocks are very low after earnings have been on the rise for many months or several years, it’s often a sign that they’re near the end of their up cycle. When P/Es are superhigh and you’ve heard nothing but doom and gloom about the company or industry for an extended period, the bottom may be near.

At the bottom of a cyclical swing, the following things happen: 1. Earnings are falling. 2. Dividends may be cut or omitted. 3. The P/E ratio is high. 4. News is generally bad. At the top of a cyclical swing: 1. Earnings are moving up. 2. Dividends are being raised. 3. The P/E ratio is low. 4. News is generally good.

Laggards usually appear to be relatively cheaper than market leaders, and that attracts unskilled investors. Don’t be tempted by a stock with a relatively low P/E or one that hasn’t appreciated as much as has the leader in its industry. There’s always a reason why one stock trades at a high multiple and another trades at a low multiple. More times than not, the expensive market leader is actually cheap and the laggard is really the more expensive choice.

How do you find which groups are leading? Follow the individual stocks. I like to track the 52-week new high list. The industry groups with a healthy number of stocks hitting new highs early in a bull market will often be the leaders. Your portfolio should consist of the best companies in the top four or five sectors.

Buying into the leading areas early in a bull market can lead to significant capital gains. Some groups start emerging late in a bull cycle and can lead during the next upturn after a bear market. It’s definitely worth investigating the industry groups in which the most stocks were resisting the decline and then subsequently broke into new highs while the market was coming off its lows or during the market’s initial few rallies.

I tend to let individual stocks lead me into an industry group or sector, taking more of a bottom-up approach as opposed to top-down. I have found that more often than not, the best stocks in the leading groups advance before it’s obvious that the group or sector is hot. Therefore, I focus on stocks and let them point me to the group.

Be on the lookout for new industries and companies with market niches, specialized expertise, proprietary technology, or a positive sector change such as deregulation. Look for new technologies or adaptations of old technologies that promise to help people work better, live longer, and enjoy life more or that help companies cut costs and improve productivity and efficiencies. Look for opportunities in companies undergoing positive changes. You can read industry trade magazines.

Just as leading stocks can at times foretell a powerful group advance, keeping an eye on the top two or three companies in an industry group could provide a tip-off to when the group may be headed for trouble. It’s important to keep your eye on important leading names in the top-performing sectors. Often you’ll see an important stock in a group break badly, and the whole group will suffer.

Once a market reaches saturation, little room remains for further penetration. Relative price declines have less and less of a positive impact on unit sales. The industry ceases to be a growth industry. In some cases, technological and manufacturing progress may lead to price declines that exceed consequent increases in unit sales. During such periods of market saturation, competitive pressures usually lead to severe declines in profit margins. A former growth industry geared to rapid sales expansion enters a period of consolidation in which competition becomes unusually intense. Such periods of consolidation are usually characterized by profit rates well below the prior industry average, a decline in the number of companies in an industry, and bankruptcies.

The fact is, no matter how big or prestigious a company is, when fundamentals deteriorate—namely, earnings—you never know how far the stock will fall.

The stock market cares little about the past, including the status of a company. What it cares about is the future, namely, growth. Keep in mind that our goal is to uncover superperformance stocks: shares that will far outpace the rest of the pack. These stocks are the ones with the strongest potential, and they seldom are found in the bargain bin.

In the stock market, it’s earnings, earnings, earnings; after all, it’s the bottom line that counts. How much money can a company earn and for how long? This leads to three basic questions every investor should ask when it comes to earnings: How much? How long? and How certain? Profitability, sustainability, and visibility represent the most influential factors that move stock prices.

Stocks move for two basic reasons: anticipation and surprise. Every price movement is rooted in one of these two elements: anticipation of news, an event, an important business change, or reaction to an unexpected event and a surprise, whether positive or negative.

Stocks often move in anticipation of good and bad news and then after the fact may move in the opposite direction (i.e., rallying in anticipation of a favorable development and selling off when the announcement is made).

That is what is meant when people say the stock market is a discounting mechanism. Although anticipation moves prices, once the expected event occurs, the market sells on the news. Hence the old adage “Buy the rumor; sell the fact”

They call it the cockroach effect because as with cockroaches, if you see one, you can bet there are others. The same thinking applies to companies reporting earnings surprises. If a company has posted very good quarterly results that are much better than were anticipated by analysts, there are probably more good quarters ahead. If a company is performing well with earnings surprises, other companies in the same industry or sector may post some upside surprises as well.

An authentic earnings surprise for the quarter probably portends higher earnings in the next quarter as well. The mirror effect often holds true for negative surprises. Companies that miss earnings estimates often disappoint again in subsequent quarters. Because earnings surprises have a lingering effect, we want to focus on companies that beat estimates and avoid firms that have negative earnings surprises. One way to find candidates is to check to see if earnings reported in the last couple of quarters were better than expected.

I like to see estimates raised not only for the current quarter but also for the current fiscal year. Studies have shown that when estimates are revised upward by 5 percent or more, stocks tend to show better-than-average performance. Conversely, with downward revisions of 5 percent or more, stocks exhibit lower than average performance.

Look for companies for which analysts are raising estimates. Quarterly as well as current fiscal year estimates should be trending higher; the bigger the estimate revisions, the better. At the very least, I like to see the current fiscal year or the next year’s estimates trending higher from 30 days earlier; if both are trending higher, that is even better. Although I won’t necessarily disqualify a stock as a buy candidate if it lacks upward earnings revisions, large downward estimate revisions are definitely a red flag.

When a company delivers several quarters of strong earnings, this not only prompts more upward revisions of analysts’ earnings estimates and brokerage upgrades but also results in more coverage of the stock as additional investment houses assign analysts to follow the company. More upbeat analysis can lead to more buying. The stock, which was hardly noticed just a few quarters ago, is starting to attract attention and bask in the limelight. If earnings accelerate quarter by quarter at a strengthening pace, earnings per share (EPS) momentum can propel the share price even higher.

At some point, the growth becomes obvious and essentially everybody knows about it. The stock is officially termed a growth stock. The smart money that got in early is getting out with a hefty profit, and naive investors step in to buy what they’ve been reading about in the financial pages or hearing about on TV. Then the momentum stalls. What follows is the loss of EPS momentum, an eventual negative earnings surprise, and downward revisions, all of which puts considerable pressure on the stock price. This earnings maturation cycle happens time and time again, market cycle after market cycle. The key is to understand where you are in the cycle and take advantage of its effect.

In order to find your next superperformer, look for stocks that are in stage 2 with strong earnings, positive surprises, and upward revised estimates.

Sometimes a company with a rocketing stock price may not be making much money, but the rising price means that investors are hoping that it will be profitable in the future. However, three out of four times, the very best performers will show meaningful earnings increases in the most recent quarter from the same quarter a year earlier. You should demand not only that the most recent quarter be up by a meaningful amount but that the past two or three quarters also show good gains.

In fact, it’s even better if the earnings are getting stronger sequentially each quarter. In our study of past superperformance stocks, as well as in the Love and Reinganum studies, current quarterly earnings showed the highest correlation with big stock price performance.

Many successful growth managers require a minimum of 20 to 25 percent year-over-year increases in the most recent one, two, or three quarters. The greater the percentage increases, the better. Really successful companies generally report earnings increases of 30 to 40 percent or more during their superperformance phase.

In addition to large earnings increases that are better than analysts expect, I’m looking for earnings acceleration, meaning that the growth in earnings is larger than it was in a previous period. More than 90 percent of the biggest stock market winners showed some form of earnings acceleration before or during their huge price moves.

In addition to strong, accelerating earnings per share growth, you want to see sales exhibit the same characteristics: strong quarterly growth and acceleration. It’s not uncommon for new market leaders to show triple-digit sales growth in the most recent two, three, or more quarters. In fact, some great stock market successes deliver large quarterly sales increases consistently for several years.

Generally, I look back one to two years to see if there has been some form of earnings and sales acceleration. Life is not perfect, and so if one quarter here or there doesn’t accelerate, it may not be a big deal. You can smooth out quarterly results by using a two-quarter rolling average over the past four, six, or eight quarters. Ideally, you want to see a steadily improving trend. In contrast, a trend of a material deceleration, with results trending sharply lower for several quarters or longer, should raise suspicion.

With turnaround situations, investors should insist that the current earnings be very strong (+100 percent or better in the most recent one or two quarters). If the previous results were dismal, the company should be doing significantly better percentagewise in light of easy comparisons. You could also insist that earnings and margins be at or close to a new high for added confirmation that the company is back on track.

A company can be doing great with high-double-digit percentage growth and then “deteriorate” to mid-double-digit growth. For another company, growing by 20 or 30 percent may be a big improvement. However, for a company that had been growing at upward of 50 to 60 percent or more, a growth rate of 20 to 30 percent would be a material deterioration.

A COMPANY CAN GENERATE EARNINGS in various ways, some not so trustworthy; I prefer high-quality earnings. In other words, where did the earnings come from? Did the company post better results because of stronger sales? If sales were strong, was it only because of a single product or one major customer? In that case, the growth is vulnerable. Or are the surprisingly strong results due to an industrywide phenomenon or an influx of orders from numerous buyers? Maybe the company is slashing costs and cutting back. Earnings improvement from cost cutting, plant closures, and other so-called productivity enhancements walks on short legs. Such improvements can show up from time to time, but sustainable earnings growth requires revenue growth. Examining earnings quality gives you perspective and rationale before you commit your hard-earned money to a stock.

The game players may even underdeliver by dropping an earnings bomb in an effort to have the estimate bar temporarily lowered for easy comparisons in the future. One gimmick is to warn the public of a potential earnings problem, which will cause analysts to lower their earnings estimates. Then the company reports earnings that are better than the lowered estimate. This will result in an earnings surprise; however, it will be a surprise in the context of a lower consensus comparison. If you see that estimate revisions were recently lowered due to downside guidance, and then the company beat expectations, this should raise a red flag; the report may not be as good as it looks on the surface.

With an understanding of the three major drivers of earnings (higher volume, higher prices, and lower costs), it pays to be cautious if a company is delivering only on cutting costs. A company can increase profits by cutting jobs, closing plants, or shedding its losing operations. However, these measures have a limited life span. Eventually, a company will have to do something else to grow its business and increase its top line. Therefore, check the story behind earnings growth. Make sure that it’s not because of a one-time event, because sales jumped as a result of some extraordinary gain, or because profits improved only as a result of cost cutting.

Companies with good potential for stock price appreciation show evidence that earnings growth is sustainable and will continue over some length of time. The ideal situation is when a company has higher sales volume with new and current products in new and existing markets as well as higher prices and reduced costs. That’s a winning combination. In general, the best growth candidates have the ability to expand, introduce new products and services, and enter new markets. They have the power to raise prices, and they can improve productivity and cut costs. The combination of revenue acceleration and margin expansion will have a dramatic effect on the bottom line. The worst situation is when a company has limited pricing power, its business is capital-intensive, margins are low or under pressure, and it’s faced with heavy regulation, intense competition, or both.

When strong earnings are reported, check the story behind the results to make sure the good news is not due to a one-time event but is the product of conditions that probably will continue. Your questions should include the following: • Are there any new products or services or positive industry changes? • Is the company gaining market share? A market is ultimately dominated by just a few companies. • What is the company doing to increase revenue and expand margins? • What is the company doing to decrease costs and increase productivity?