Any company can report a good earnings quarter every once in a while. And as
we’ve seen, strong current quarterly earnings are critical to picking most of
the market’s biggest winners. But they’re not enough.
To make sure the latest results aren’t just a flash in the pan, and the com-
pany you’re looking at is of high quality, you must insist on more proof. The
way to do that is by reviewing the company’s annual earnings growth rate.
Look for annual earnings per share that have increased in each of the last
three years. You normally don’t want the second year’s earnings to be down,
even if the results in the following year rebound to the highest level yet. It’s
the combination of strong earnings in the last several quarters plus a record
of solid growth in recent years that creates a superb stock, or at least one
with a higher probability of success during an uptrending general market.
Select Stocks with 25% to 50% and Higher Annual Earnings Growth Rates
The annual rate of earnings growth for the companies you pick should be
25%, 50%, or even 100% or more. Between 1980 and 2000, the median
annual growth rate of all outstanding stocks in our study at their early
emerging stage was 36%. Three out of four big winners showed at least
some positive annual growth over the three years, and in some cases the five
years, preceding the stocks’ big run-ups.
A typical earnings per share progression for the five years preceding the
stock’s move might be something like $0.70, $1.15, $1.85, $2.65, and $4.00.
In a few cases, you might accept one down year in five as long as the follow-
ing year’s earnings move back to new high ground.
It’s possible a company could earn $4.00 a share one year, $5.00 the next,
$6.00 the next, and then $3.00 a share. If the next annual earnings statement
was, say, $4.00 per share versus the prior year’s $3.00, this would not be a
good report despite the 33% increase over the prior year. The only reason it
might seem positive is that the previous year’s earnings ($3.00 a share) were
so depressed that any improvement would look good. The point is, profits
are recovering slowly and are still well below the company’s peak annual
earnings of $6.00 a share.
The consensus among analysts on what earnings will be for the next year
should also be up—the more, the better. But remember: estimates are per-
sonal opinions, and opinions may be wrong (too high or too low). Actual
reported earnings are facts.
Look for a Big Return on Equity
You should also be aware of two other measurements of profitability and
growth: return on equity and cash flow per share.
Return on equity, or ROE, is calculated by dividing net income by share-
holders’ equity. This shows how efficiently a company uses its money,
thereby helping to separate well-managed firms from those that are poorly
managed. Our studies show that nearly all the greatest growth stocks of the
past 50 years had ROEs of at least 17%. (The really superior growth situa-
tions will sport 25% to 50% ROEs.)
To determine cash flow, add back the amount of depreciation the com-
pany shows to reflect the amount of cash that is being generated internally.
Some growth stocks can also show annual cash flow per share that is at least
20% greater than actual earnings per share.
Check the Stability of a Company’s Three-Year Earnings Record
Through our research, we’ve determined another factor that has proved
important in selecting growth stocks: the stability and consistency of annual
earnings growth over the past three years. Our stability measurement,
which is expressed on a scale of 1 to 99, is calculated differently from most
statistics. The lower the figure, the more stable the past earnings record.
The figures are calculated by plotting quarterly earnings for the past three
or five years and fitting a trend line around the plotted points to determine
the degree of deviation from the basic growth trend.
Growth stocks with steady earnings tend to have a stability figure below 20
or 25. Companies with stability ratings over 30 are more cyclical and a little
less dependable in terms of their growth. All other things being equal, you
may want to look for stocks showing a greater degree of sustainability, con-
sistency, and stability in past earnings growth. Some companies that are
growing 25% per year could have a stability rating of 1, 2, or 3. When the
quarterly earnings for several years are plotted on a log-scale chart, the earn-
ings line should be nearly straight, consistently moving up. In most cases
there will be some acceleration in the rate of increase in recent quarters.
Earnings stability numbers are customarily shown right after a company’s
annual growth rate, but most analysts and investment services don’t bother
to make the calculation. We show them in many of our institutional products
as well as in Daily Graphs and Daily Graphs Online, which are designed for
individual investors.
If you restrict your stock selections to ventures with proven growth
records, you will avoid the hundreds of investments with erratic histories or
cyclical recoveries in profits. A few such stocks could “top out” as they
approach the peaks of their prior earnings cycle.
What Is a Normal Stock Market Cycle?
History demonstrates most bull (up) markets last two to four years and are fol-
lowed by a recession or a bear (down) market. Then another bull market starts.
In the beginning phase of a new bull market, growth stocks are usually
the first to lead and make new price highs. These are companies whose
profits have grown quarter to quarter, but whose stocks have been held back
by the poor general market conditions. The combination of a general mar-
ket decline and a stock’s continued profit growth will have compressed the
price/earnings (P/E) ratio to a point where it is attractive to institutional
investors, for whom P/Es are important.
Cyclical stocks in basic industries such as steel, chemicals, paper, rubber,
autos, and machinery usually lag in the new bull market’s early phase.
Young growth stocks will typically dominate for at least two bull market
cycles. Then the emphasis may change to cyclicals, turnarounds, or other
newly improved sectors for a short period.
While three out of four big market winners in the past were growth
stocks, one in four was a cyclical or turnaround situation. In 1982, Chrysler
and Ford were two such spirited turnaround plays. Cyclical and turnaround
opportunities led in the market waves of 1953–1955, 1963–1965, and
1974–1975. Cyclicals including paper, aluminum, autos, chemicals, and
plastics returned to the fore in 1987, and home-building stocks, which are
also cyclical, have led in other periods. Examples of turnaround situations
include IBM in 1994 and Apple in 2003.
Yet even when cyclical stocks are in favor, some pretty dramatic young
growth issues are also available. Cyclical stocks in the United States are often
those in older, less-efficient industries. Some of these companies weren’t
competitive until the demand for steel, copper, chemicals, and oil surged as
a result of the rapid buildup of basic industries in China. That’s why cyclicals
were resurrected aggressively after the 2000 bear market ended in 2003.
They are still cyclical stocks, however, and they may not represent Amer-
ica’s true future. In addition, large, old-line companies in America fre-
quently have the added disadvantage of size: they are simply too large to be
able to innovate and continually renew themselves so that they can compete
with nimble foreign rivals and with America’s young new entrepreneurs.
Rallies in cyclical stocks may tend to be more short-lived and prone to falter
at the first hint of a recession or an earnings slowdown. Should you decide to
buy a turnaround stock, look for annual earnings growth of at least 5% to 10%
and two straight quarters of sharp earnings recovery that lift results for the lat-
est 12 months into or very near new high ground. Check the 12-month earnings
line on a stock chart; the sharper the angle of the earnings upswing, the better.
If the profit upswing is so dramatic that it reaches a new high, one quar-
ter of earnings turnaround will sometimes suffice. Cleveland Cliffs, a sup-
plier of iron ore pellets to the steel industry (and now known as Cliffs
Natural Resources), came from a deficit position to dramatically accelerate
quarterly earnings in 2004 by 64% and then by 241%. With that impetus,
the stock rapidly advanced 170% in the next eight months.
we’ve seen, strong current quarterly earnings are critical to picking most of
the market’s biggest winners. But they’re not enough.
To make sure the latest results aren’t just a flash in the pan, and the com-
pany you’re looking at is of high quality, you must insist on more proof. The
way to do that is by reviewing the company’s annual earnings growth rate.
Look for annual earnings per share that have increased in each of the last
three years. You normally don’t want the second year’s earnings to be down,
even if the results in the following year rebound to the highest level yet. It’s
the combination of strong earnings in the last several quarters plus a record
of solid growth in recent years that creates a superb stock, or at least one
with a higher probability of success during an uptrending general market.
Select Stocks with 25% to 50% and Higher Annual Earnings Growth Rates
The annual rate of earnings growth for the companies you pick should be
25%, 50%, or even 100% or more. Between 1980 and 2000, the median
annual growth rate of all outstanding stocks in our study at their early
emerging stage was 36%. Three out of four big winners showed at least
some positive annual growth over the three years, and in some cases the five
years, preceding the stocks’ big run-ups.
A typical earnings per share progression for the five years preceding the
stock’s move might be something like $0.70, $1.15, $1.85, $2.65, and $4.00.
In a few cases, you might accept one down year in five as long as the follow-
ing year’s earnings move back to new high ground.
It’s possible a company could earn $4.00 a share one year, $5.00 the next,
$6.00 the next, and then $3.00 a share. If the next annual earnings statement
was, say, $4.00 per share versus the prior year’s $3.00, this would not be a
good report despite the 33% increase over the prior year. The only reason it
might seem positive is that the previous year’s earnings ($3.00 a share) were
so depressed that any improvement would look good. The point is, profits
are recovering slowly and are still well below the company’s peak annual
earnings of $6.00 a share.
The consensus among analysts on what earnings will be for the next year
should also be up—the more, the better. But remember: estimates are per-
sonal opinions, and opinions may be wrong (too high or too low). Actual
reported earnings are facts.
Look for a Big Return on Equity
You should also be aware of two other measurements of profitability and
growth: return on equity and cash flow per share.
Return on equity, or ROE, is calculated by dividing net income by share-
holders’ equity. This shows how efficiently a company uses its money,
thereby helping to separate well-managed firms from those that are poorly
managed. Our studies show that nearly all the greatest growth stocks of the
past 50 years had ROEs of at least 17%. (The really superior growth situa-
tions will sport 25% to 50% ROEs.)
To determine cash flow, add back the amount of depreciation the com-
pany shows to reflect the amount of cash that is being generated internally.
Some growth stocks can also show annual cash flow per share that is at least
20% greater than actual earnings per share.
Check the Stability of a Company’s Three-Year Earnings Record
Through our research, we’ve determined another factor that has proved
important in selecting growth stocks: the stability and consistency of annual
earnings growth over the past three years. Our stability measurement,
which is expressed on a scale of 1 to 99, is calculated differently from most
statistics. The lower the figure, the more stable the past earnings record.
The figures are calculated by plotting quarterly earnings for the past three
or five years and fitting a trend line around the plotted points to determine
the degree of deviation from the basic growth trend.
Growth stocks with steady earnings tend to have a stability figure below 20
or 25. Companies with stability ratings over 30 are more cyclical and a little
less dependable in terms of their growth. All other things being equal, you
may want to look for stocks showing a greater degree of sustainability, con-
sistency, and stability in past earnings growth. Some companies that are
growing 25% per year could have a stability rating of 1, 2, or 3. When the
quarterly earnings for several years are plotted on a log-scale chart, the earn-
ings line should be nearly straight, consistently moving up. In most cases
there will be some acceleration in the rate of increase in recent quarters.
Earnings stability numbers are customarily shown right after a company’s
annual growth rate, but most analysts and investment services don’t bother
to make the calculation. We show them in many of our institutional products
as well as in Daily Graphs and Daily Graphs Online, which are designed for
individual investors.
If you restrict your stock selections to ventures with proven growth
records, you will avoid the hundreds of investments with erratic histories or
cyclical recoveries in profits. A few such stocks could “top out” as they
approach the peaks of their prior earnings cycle.
What Is a Normal Stock Market Cycle?
History demonstrates most bull (up) markets last two to four years and are fol-
lowed by a recession or a bear (down) market. Then another bull market starts.
In the beginning phase of a new bull market, growth stocks are usually
the first to lead and make new price highs. These are companies whose
profits have grown quarter to quarter, but whose stocks have been held back
by the poor general market conditions. The combination of a general mar-
ket decline and a stock’s continued profit growth will have compressed the
price/earnings (P/E) ratio to a point where it is attractive to institutional
investors, for whom P/Es are important.
Cyclical stocks in basic industries such as steel, chemicals, paper, rubber,
autos, and machinery usually lag in the new bull market’s early phase.
Young growth stocks will typically dominate for at least two bull market
cycles. Then the emphasis may change to cyclicals, turnarounds, or other
newly improved sectors for a short period.
While three out of four big market winners in the past were growth
stocks, one in four was a cyclical or turnaround situation. In 1982, Chrysler
and Ford were two such spirited turnaround plays. Cyclical and turnaround
opportunities led in the market waves of 1953–1955, 1963–1965, and
1974–1975. Cyclicals including paper, aluminum, autos, chemicals, and
plastics returned to the fore in 1987, and home-building stocks, which are
also cyclical, have led in other periods. Examples of turnaround situations
include IBM in 1994 and Apple in 2003.
Yet even when cyclical stocks are in favor, some pretty dramatic young
growth issues are also available. Cyclical stocks in the United States are often
those in older, less-efficient industries. Some of these companies weren’t
competitive until the demand for steel, copper, chemicals, and oil surged as
a result of the rapid buildup of basic industries in China. That’s why cyclicals
were resurrected aggressively after the 2000 bear market ended in 2003.
They are still cyclical stocks, however, and they may not represent Amer-
ica’s true future. In addition, large, old-line companies in America fre-
quently have the added disadvantage of size: they are simply too large to be
able to innovate and continually renew themselves so that they can compete
with nimble foreign rivals and with America’s young new entrepreneurs.
Rallies in cyclical stocks may tend to be more short-lived and prone to falter
at the first hint of a recession or an earnings slowdown. Should you decide to
buy a turnaround stock, look for annual earnings growth of at least 5% to 10%
and two straight quarters of sharp earnings recovery that lift results for the lat-
est 12 months into or very near new high ground. Check the 12-month earnings
line on a stock chart; the sharper the angle of the earnings upswing, the better.
If the profit upswing is so dramatic that it reaches a new high, one quar-
ter of earnings turnaround will sometimes suffice. Cleveland Cliffs, a sup-
plier of iron ore pellets to the steel industry (and now known as Cliffs
Natural Resources), came from a deficit position to dramatically accelerate
quarterly earnings in 2004 by 64% and then by 241%. With that impetus,
the stock rapidly advanced 170% in the next eight months.
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