Dell Computer, Cisco Systems, America Online—why, among the thousands of stocks that trade each day, did these three perform so well during the 1990s, posting gains of 1,780%, 1,467%, and 557%, respectively?
Or for that matter, what about Google, which started trading at $85 a share in August 2004 and didn’t stop climbing until it peaked at over $700 in 2007? Or Apple, which had emerged from a perfect cup-with-handle pattern six months earlier at a split-adjusted $12 a share and reached $202 in 45 months?
What key traits, among the hundreds that can move stocks up and down, did these companies all have in common?
These are not idle questions. The answers unlock the secret to true success in the stock market. Our study of all the stock market superstars from the last century and a quarter found that they did indeed share common characteristics.
None of these characteristics, however, stood out as boldly as the large percentage earnings per share increase each big winner reported in the latest quarter or two before its major price advance. For example:
• Dell’s earnings per share surged 74% and 108% in the two quarters prior to its price increase from November 1996.
• Cisco posted earnings gains of 150% and 155% in the two quarters ending October 1990, prior to its giant run-up over the next three years.
• America Online’s earnings were up 900% and 283% before its six-month burst from October 1998.
• Google showed earnings gains of 112% and 123% in the two quarters before it made its spectacular debut as a public company.
• Apple’s earnings were up 350% in the quarter before it took off, and its next quarter was up another 300%.
But this isn’t just a recent phenomenon. Explosive earnings have accompanied big stock moves throughout the stock market’s great history in America. Studebaker’s earnings were up 296% before it sped from $45 to $190 in eight months in 1914, and Cuban American Sugar’s earnings soared 1,175% in 1916, the same year its stock climbed from $35 to $230.
In the summer of 1919, Stutz Motor Car was showing an earnings gain of 70% before the prestigious manufacturer of high-performance sports cars—you remember the Bearcat, don’t you?—raced from $75 to $385 in just 40 weeks.
Earnings at U.S. Cast Iron Pipe rose from $1.51 a share at the end of 1922 to $21.92 at the end of 1923, an increase of 1,352%. In late 1923, the stock traded at $30; by early 1925, it went for $250.
And in March of 1926, du Pont de Nemours showed earnings up 259% before its stock took off from $41 that July and got to $230 before the 1929 break.
In fact, if you look down a list of the market’s biggest winners year-in and year-out, you’ll instantly see the relationship between booming profits and booming stocks.
And you’ll see why our studies have concluded that
The stocks you select should show a major percentage increase in current
quarterly earnings per share (the most recently reported quarter)
when compared to the prior year’s same quarter.
In our models of the 600 best-performing stocks from 1952 to 2001, three out of four showed earnings increases averaging more than 70% in the latest publicly reported quarter before they began their major advances. Those that did not show solid current quarterly earnings increases did so in the very next quarter, with an average earnings increase of 90%!
Priceline.com was showing earnings up “only” 34% in the June quarter of 2006, when its stock began a move from $30 to $140. But its earnings accelerated, rising 53%, 107%, and 126%, in the quarters that followed.
From 1910 to 1950, most of the very best performers showed quarterly earnings gains ranging from 40% to 400% before their big price moves.
So, if the best stocks had profit increases of this magnitude before they advanced rapidly in price, why should you settle for anything less? You may find that only 1% or 2% of stocks listed on Nasdaq or the New York Stock Exchange show earnings gains of this size. But remember: you’re looking for stocks that are exceptional, not lackluster. Don’t worry; they’re out there.
As with any search, however, there can be traps and pitfalls along the way, and you need to know how to avoid them.
The earnings per share (EPS) number you want to focus on is calculated by dividing a company’s total after-tax profits by the number of common shares outstanding. This percentage change in EPS is the single most important element in stock selection today. The greater the percentage increase, the better.
And yet during the Internet boom of the wild late 1990s, some people bought stocks based on nothing more than big stories of profits and riches to come, as most Internet and dot-com companies had shown only deficits to date. Given that companies such as AOL and Yahoo! were actually showing earnings, risking your hard-earned money in other, unproven stocks was simply not necessary.
AOL and Yahoo! were the real leaders at that time. When the inevitable market correction (downturn) hit, lower-grade, more speculative companies with no earnings rapidly suffered the largest declines. You don’t need that added risk.
I am continually amazed at how some professional money managers, let alone individual investors, buy common stocks when the current reported quarter’s earnings are flat (no change) or down. There is absolutely no good reason for a stock to go anywhere in a big, sustainable way if its current earnings are poor.
Even profit gains of 5% to 10% are insufficient to fuel a major price movement in a stock. Besides, a company showing an increase of as little as 8% or 10% is more likely to suddenly report lower or slower earnings the next quarter.
Unlike some institutional investors such as mutual funds, banks, and insurance companies, which have billions under management and which may be restricted by the size of their funds, individual investors have the luxury of investing in only the very best stocks in each bull cycle. While some companies with no earnings (like Amazon.com and Priceline.com) had big moves in their stocks in 1998–1999, most investors in that time period would have been better off buying stocks like America Online and Charles Schwab, both of which had strong earnings.
Following the CAN SLIM strategy’s emphasis on earnings ensures that an investor will always be led to the strongest stocks in any market cycle, regardless of any temporary, highly speculative “bubbles” or euphoria. Of course, you never buy on earnings growth alone. Several other factors, which we’ll cover in the chapters that follow, are also essential. It’s just that EPS percentage increase is the most important.
Have you ever read a corporation’s quarterly earnings report that went like this:
We had a terrible first three months. Prospects for our company are turning down because of inefficiencies at the home office. Our competition just came out with a better product, which will adversely affect our sales. Furthermore, we are losing our shirt on the new Midwestern operation, which was a real blunder on management’s part.
No way! Here’s what you see instead:
Greatshakes Corporation reports record sales of $7.2 million versus $6 million (+20%) for the quarter ended March 31.
If you’re a Greatshakes stockholder, this sounds like wonderful news. You certainly aren’t going to be disappointed. After all, you believe that this is a fine company (if you didn’t, you wouldn’t have invested in it in the first place), and the report confirms your thinking.
But is this “record-breaking” sales announcement a good report? Let’s suppose the company also had record earnings of $2.10 per share, up 5% from the $2.00 per share reported for the same quarter a year ago. Is it even better now? The question you have to ask is, why were sales up 20% but earnings ahead only 5%? What does this say about the company’s profit margins?
Most investors are impressed with what they read, and companies love to put their best foot forward in their press releases and TV appearances. However, even though this company’s sales grew 20% to an all-time high, it didn’t mean much for the company’s profits. The key question for the winning investor must always be:
How much are the current quarter’s earnings per share up
(in percentage terms) from the same quarter the year before?
Let’s say your company discloses that sales climbed 10% and net income advanced 12%. Sound good? Not necessarily. You shouldn’t be concerned with the company’s total net income. You don’t own the whole organization; you own shares in it. Over the last 12 months, the company might have issued additional shares or “diluted” the common stock in other ways. So while net income may be up 12%, earnings per share—your main focus as an investor—may have edged up only 5% or 6%.
You must be able to see through slanted presentations. Don’t let the use of words like sales and net income divert your attention from the truly vital facts like current quarterly earnings. To further clarify this point:
You should always compare a company’s earnings per share to the same
quarter a year earlier, not to the prior quarter, to avoid any distortion
resulting from seasonality. In other words, you don’t compare the
December quarter’s earnings per share to the prior September quarter’s
earnings per share. Rather, compare the December quarter to the
December quarter of the previous year for a more accurate evaluation.
The winning investor should avoid the trap of being influenced by nonrecurring profits. For example, if a computer maker reports earnings for the last quarter that include nonrecurring profits from activities such as the sale of real estate, this portion of earnings should be subtracted from the report. Such earnings represent a one-time event, not the true, ongoing profitability of corporate operations. Ignore the earnings that result from such events.
Is it possible that the earnings of New York’s Citigroup bank may have been propped up at times during the 1990s by nonrecurring sales of commercial real estate prior to the bank’s later leveraged involvement in the subprime disaster?
Whether you’re a new or an experienced investor, I would advise against buying any stock that doesn’t show earnings per share up at least 18% or 20% in the most recent quarter versus the same quarter the year before. In our study of the greatest winning companies, we found that they all had this in common prior to their big price moves. Many successful investors use 25% or 30% as their minimum earnings parameter.
To be even safer, insist that both of the last two quarters show significant earnings gains. During bull markets (major market uptrends), I prefer to concentrate on stocks that show powerful earnings gains of 40% to 500% or more. You have thousands of stocks to choose from. Why not buy the very best merchandise available?
To further sharpen your stock selection process, look ahead to the next quarter or two and check the earnings that were reported for those same quarters the previous year. See if the company will be coming up against unusually large or small earnings achieved a year ago. When the unusual year-earlier results are not caused by seasonal factors, this step may help you anticipate a strong or poor earnings report in the coming months.
Also, be sure to check consensus earnings estimates (projections that combine the earnings estimates of a large group of analysts) for the next several quarters—and for the next year or two—to make sure the company is projected to be on a positive track. Some earnings estimate services even show an estimated annual earnings growth rate for the next five years for many companies.
Many individuals and even some institutional investors buy stocks whose earnings were down in the most recently reported quarter because they like the company and think that its stock price is “cheap.” Usually they accept the story that earnings will rebound strongly in the near future. In some cases this may be true, but in many cases it isn’t. Again, the point is that you have the choice of investing in thousands of companies, many of which are actually showing strong operating results. You don’t have to accept promises of earnings that may never occur.
Requiring that current quarterly earnings be up a hefty amount is just another smart way for the intelligent investor to reduce the risk of mistakes in stock selection. But you must also understand in the late stage of a bull market, some or even many leaders that have had long runs can top out even though their current earnings are up 100%. This usually fools investors and analysts alike. It pays to know your market history.
In fact, many older American corporations have mediocre management that continually produces second-rate earnings results. I call these people the “entrenched maintainers” or “caretaker management.” You want to avoid these companies until someone has the courage to change the top executives. Not coincidentally, they are generally the companies that strain to pump up their current earnings a still-dull 8% or 10%. True growth companies with outstanding new products or improved management do not have to inflate their current results.
Our analysis of the most successful stocks also showed that, in almost every case, earnings growth accelerated sometime in the 10 quarters before a towering price move began. In other words, it’s not just increased earnings and the size of the increase that cause a big move. It’s also that the increase represents an improvement from the company’s prior rate of earnings growth. If a company’s earnings have been up 15% a year and suddenly begin spurting 40% to 50% or more—what Wall Street usually calls “earnings surprises”—this usually creates the conditions for important stock price improvement.
Other valuable ways to track a stock’s earnings include determining how many times in recent months analysts have raised their estimates for the company plus the percentage by which several previous quarterly earnings reports have actually beaten their consensus estimates.
Strong and improving quarterly earnings should always be supported by sales growth of at least 25% for the latest quarter, or at least an acceleration in the rate of sales percentage improvement over the last three quarters. Certain superior newer issues (initial public offerings) may show sales growth averaging 100% or more in each of the prior 8, 10, or 12 quarters. Check all these stocks out.
Take particular note if the growth of both sales and earnings has accelerated for the last three quarters. You don’t want to get impatient and sell your stock if it shows this type of acceleration. Stick to your position.
Some professional investors bought Waste Management at $50 in early 1998 because earnings had jumped three quarters in a row from 24% to 75% and 268%. But sales were up only 5%. Several months later, the stock collapsed to $15 a share.
This demonstrates that companies can inflate earnings for a few quarters by reducing costs or spending less on advertising, research and development, and other constructive activities. To be sustainable, however, earnings growth must be supported by higher sales. Such was not the case with Waste Management.
It will also improve your batting average if the latest quarter’s after-tax profit margins for your stock selections are at or near a new high and among the very best in the company’s industry. Yes, you have to do a little homework if you want to really improve your results. No pain, no gain.
Just as it’s important to recognize when quarterly earnings growth is accelerating, it’s also important to know when earnings begin to decelerate, or slow down significantly. If a company that has been growing at a quarterly rate of 50% suddenly reports earnings gains of only 15%, that might spell trouble, and you may want to avoid that company.
Even the best organizations can have a slow quarter every once in a while. So before turning negative on a company’s earnings, I prefer to see two consecutive quarters of material slowdown. This usually means a decline of two-thirds or greater from the previous rate—a slowdown from 100% earnings growth to 30%, for example, or from 50% to 15%.
Understanding the principle of earnings acceleration or deceleration is essential.
Securities analysts who recommend stocks because of the absolute level of earnings expected for the following year could be looking at the wrong set of numbers. The fact that a stock earned $5 per share and expects to report $6 the next year (a “favorable” 20% increase) could be misleading unless you know the previous trend in the percentage rate of earnings change. What if earnings were previously up 60%? This partially explains why so few investors make significant money following the buy and sell recommendations of securities analysts.
Logarithmic-scale graphs are of great value in analyzing stocks because they can clearly show acceleration or deceleration in the percentage rate of quarterly earnings increases. One inch anywhere on the price or earnings scale represents the same percentage change. This is not true of arithmetically scaled charts.
On arithmetically scaled charts, a 100% price move from $10 to $20 shows the same space change as a 50% increase from $20 to $30. But a log-scale graph shows a 100% increase as twice as large as the 50% increase. Weekly charts in Daily Graphs Online are properly logarithmic.
As a do-it-yourself investor, you can take the latest quarterly earnings per share along with the prior three quarters’ EPS, and plot them on a logarithmic-scale graph to get a clear picture of earnings acceleration or deceleration. For the best companies, plotting the most recent 12-month earnings each quarter should put the earnings per share point close to or already at new highs.
For additional validation, check the earnings of other companies in your stock’s industry group. If you can’t find at least one other impressive stock displaying strong earnings in the group, chances are you may have selected the wrong investment.
Quarterly corporate earnings statements used to be published in the business sections of most local newspapers and financial publications every day. But most newspapers have downsized their business sections these days, dropping data right and left. As a result, they no longer adequately cover the critical facts investors need to know.
This is not true of Investor’s Business Daily. IBD not only continues to provide detailed earnings coverage, but goes a step further and separates all new earnings reports into companies with “up” earnings and those reporting “down” results, so you can easily see who produced excellent gains and who didn’t.
Chart services such as Daily Graphs® and Daily Graphs Online also show earnings reported during the week as well as the most recent earnings figures for every stock they chart. Once you locate the percentage change in earnings per share when compared to the same year-ago quarter, also compare the percentage change in EPS on a quarter-by-quarter basis. Looking at the March quarter and then at the June, September, and December quarters will tell you if a company’s earnings growth is accelerating or decelerating.
You now have the first crucial rule for improving your stock selection:
Current quarterly earnings per share should be up a major
percentage—25% to 50% at a minimum—over the same quarter the
previous year. The best companies can show earnings
up 100% to 500% or more!
A mediocre 10% or 12% isn’t enough. When you’re picking winning stocks, it’s the bottom line that counts.