Omit a Company’s One-Time Extraordinary Gains
The winning investor should avoid the trap of being influenced by nonre-
curring 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 profitabil-
ity 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 com-
mercial real estate prior to the bank’s later leveraged involvement in the
subprime disaster?
Set a Minimum Level for Current Earnings Increases
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 sev-
eral 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 that in the late stage of a
bull market, some or even many leaders that have had long runs may top out
even though their earnings are up 100%. This usually fools investors and
analysts alike. It pays to know your market history.
Avoid Big Older Companies with Maintainer Management
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 execu-
tives. Not coincidentally, they are generally the companies that strain to
pump up their current earnings a still-dull 8% or 10%. True growth compa-
nies with outstanding new products or improved management do not have
to inflate their current results.
Look for Accelerating Quarterly Earnings Growth
Our analysis of the most successful stocks also showed that, in almost every
case, earnings growth accelerated sometime in the 10 quarters before a tow-
ering 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 rep-
resents 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 spurt-
ing 40% to 50% or more—what Wall Street usually calls “earnings sur-
prises”—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 earn-
ings reports have actually beaten the estimates.
Look for Sales Growth as Well as Earnings Growth
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 newer issues (initial public offerings) may show sales growth aver-
aging 100% or more in each of the last 8, 10, or 12 quarters. Check all these
stocks out.
Take particular note if the growth of both sales and earnings has acceler-
ated 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 develop-
ment, 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 also helps improve your batting average if the latest quarter’s after-tax
profit margins for your stock selections are either at or near a new high and
among the very best in the company’s own industry. Yes, you have to do a lit-
tle homework if you want to really improve your results. No pain, no gain.
Two Quarters of Major Earnings Deceleration Can Be Trouble for Your Stock
Just as it’s important to recognize when quarterly earnings growth is accel-
erating, 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 con-
secutive quarters of material slowdown. This usually means a decline of
two-thirds or greater from the previous rate—a slowdown from 100% earn-
ings growth to 30%, for example, or from 50% to 15%.
Consult Log-Scale Weekly Graphs
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 recommenda-
tions of securities analysts.
Logarithmic-scale graphs are of great value in analyzing stocks because
they clearly show the 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 arithmeti-
cally scaled charts.
On an arithmetically scaled chart, a 100% price increase from $10 to $20
a share shows the same space change as a 50% increase from $20 to $30 a
share. In contrast, a log-scale graph would show the 100% increase as being
twice as large as the 50% increase.
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 logarith-
mic-scale graph to get a clear picture of earnings acceleration or decelera-
tion. 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.
Check Other Stocks in the Group
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.
Where to Find Current Quarterly Earnings Reports
Quarterly corporate earnings statements used to be published in the busi-
ness sections of most local newspapers and financial publications every day.
But many publications are downsizing their business sections these days,
dropping data right and left. As a result, they no longer adequately cover the
most important thing that 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 earn-
ings 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 critical 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 might 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.
The winning investor should avoid the trap of being influenced by nonre-
curring 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 profitabil-
ity 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 com-
mercial real estate prior to the bank’s later leveraged involvement in the
subprime disaster?
Set a Minimum Level for Current Earnings Increases
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 sev-
eral 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 that in the late stage of a
bull market, some or even many leaders that have had long runs may top out
even though their earnings are up 100%. This usually fools investors and
analysts alike. It pays to know your market history.
Avoid Big Older Companies with Maintainer Management
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 execu-
tives. Not coincidentally, they are generally the companies that strain to
pump up their current earnings a still-dull 8% or 10%. True growth compa-
nies with outstanding new products or improved management do not have
to inflate their current results.
Look for Accelerating Quarterly Earnings Growth
Our analysis of the most successful stocks also showed that, in almost every
case, earnings growth accelerated sometime in the 10 quarters before a tow-
ering 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 rep-
resents 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 spurt-
ing 40% to 50% or more—what Wall Street usually calls “earnings sur-
prises”—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 earn-
ings reports have actually beaten the estimates.
Look for Sales Growth as Well as Earnings Growth
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 newer issues (initial public offerings) may show sales growth aver-
aging 100% or more in each of the last 8, 10, or 12 quarters. Check all these
stocks out.
Take particular note if the growth of both sales and earnings has acceler-
ated 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 develop-
ment, 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 also helps improve your batting average if the latest quarter’s after-tax
profit margins for your stock selections are either at or near a new high and
among the very best in the company’s own industry. Yes, you have to do a lit-
tle homework if you want to really improve your results. No pain, no gain.
Two Quarters of Major Earnings Deceleration Can Be Trouble for Your Stock
Just as it’s important to recognize when quarterly earnings growth is accel-
erating, 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 con-
secutive quarters of material slowdown. This usually means a decline of
two-thirds or greater from the previous rate—a slowdown from 100% earn-
ings growth to 30%, for example, or from 50% to 15%.
Consult Log-Scale Weekly Graphs
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 recommenda-
tions of securities analysts.
Logarithmic-scale graphs are of great value in analyzing stocks because
they clearly show the 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 arithmeti-
cally scaled charts.
On an arithmetically scaled chart, a 100% price increase from $10 to $20
a share shows the same space change as a 50% increase from $20 to $30 a
share. In contrast, a log-scale graph would show the 100% increase as being
twice as large as the 50% increase.
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 logarith-
mic-scale graph to get a clear picture of earnings acceleration or decelera-
tion. 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.
Check Other Stocks in the Group
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.
Where to Find Current Quarterly Earnings Reports
Quarterly corporate earnings statements used to be published in the busi-
ness sections of most local newspapers and financial publications every day.
But many publications are downsizing their business sections these days,
dropping data right and left. As a result, they no longer adequately cover the
most important thing that 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 earn-
ings 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 critical 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 might 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.
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