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Four Important Stock Picking Factors

I recently did some research that unearthed four factors that should help growth investors pick better stocks.

Growth investors search out fast growing stocks in terms of sales and earnings—stocks like Apple and Google. My strategy wouldn’t work for value investors who look for out-of-favor stocks that have been tripped-up by short-term events—think BP.

The four growth stock factors are relative strength, expected long-term earnings growth, profitability, and recent earnings surprises. I’ll define them in detail while I describe my strategy for using them. Three of them are available on many financial sites, but MSN Money is the only resource I’ve found for relative strength. So, I’ll refer to MSN Money (moneycentral.msn.com) in my descriptions.

Relative Strength
Relative strength measures how a stock’s share price has performed compared to the overall market. For instance, a 65% relative strength means that a stock outperformed 65% of all stocks over a specified timeframe.

For each stock, MSN Money displays the relative strength (Company Report) for three different timeframes: three months, six months, and 12 months. So, if a stock’s 12-month relative strength is 90, that means that it has outperformed 90% of all stocks over the past 12-months.

My research found that, for relative strength, higher is better. For instance, stocks with relative strengths above 90, will, as a group, outperform stocks with relative strengths below 90. Further, the outperformance typically persists for at least six months.

The relative strength timeframe also affects results. While the effect works over all three of the timeframes that MSN Money displays; the shorter the timeframe, the stronger the results.

In summary, for relative strength, your best prospects will have minimum 90 relative strengths measured over the past three months.

Earnings Growth Forecasts
In addition to publishing buy/sell advice, stock analysts also forecast earnings growth for the stocks that they follow. The forecasts cover periods such as the current and next quarters (three months) and fiscal years, as well as longer timeframes. Financial sites compile the individual analyst forecasts for each stock into consensus (average) forecasts. You can see them on MSN Money by selecting Earning Estimates on the Research menu.

While investors pay most attention to the quarter and fiscal year numbers, my research found that the long-term forecasts (three to five years) work better for pinpointing the best stocks. You can find them on MSN Money by selecting the Earnings Growth Rates tab in the Earnings Estimates section.

Using the “Next 5 Years” numbers, look for minimum 25% forecast average annual earnings growth, and higher is better. In fact, I’ve found the best results come from stocks with 40% or higher expected long-term earnings growth. 

Profitability
Profitability measures how efficiently a firm uses its assets to generate profits. The more profitable the company, the faster it can grow without resorting to outside sources such as borrowing or selling more shares to fund its growth.

Return on equity (net income divided by book value) is the most widely followed profitability ratio. Professional money managers typically require at least 15% ROE. Sticking with that minimum will improve your returns but you’ll get the best results by upping that minimum to 25 or even 30%. Find ROE on MSN Money by selecting Financial Results, then Key Ratios, and then Investment Returns.

Earnings Surprise
An earnings surprise is the difference between reported earnings and analysts’ forecasts. It’s a positive surprise when earnings beat forecasts and a negative surprise when they fall short. As you’ve probably noticed, significant positive surprises, say more than 10%, often drive share prices up on report day. Same thing in reverse. Negative surprises drive share prices down. But, there’s more.

Considerable research has found that the surprise effect persists. That is, positive surprise stocks, as a group, continue to outperform for several weeks. However, I discovered that the effect is even more pronounced for stocks with significant positive surprises in the last two quarters. How much is significant? Two consecutive 20% surprises works, but 30% is even better.

On MSN Money, you can see the last five quarters’ surprise data by selecting the Earnings Surprise tab in the Earnings Estimates section. The “% Change” row lists the surprise percentage for each quarter.

In practice, you’ll find it difficult to find stocks that meet my requirements for all four factors. Here’s how I would prioritize them, with the most important first: relative strength, earnings growth forecasts, earnings surprise, and profitability.

Keep in mind that meeting these criteria won’t guarantee that you’ll make money owning these stocks. In the stock market, nothing works all of the time. Consider them as another tool for your analysis toolbox.

published 11/7/10

 

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