Can This Stock Go Any Higher?

"This stock has already gone up so far, it can't possibly go any higher."

That phrase runs through my head every time I see a chart of some high-flying stock that's gone up three-, five-, or tenfold. I remember thinking it with Starbucks in 1997, and China Mobile (NYSE: CHL  ) in 2006. In the past, I'd often watch in disbelief as the stock I'd doubted surged even higher.

Though I bought Starbucks, I missed out on China Mobile -- and countless more. Thankfully, I've figured out a new way of looking at stocks.

Don't vote by chart
The problem I share with many other investors is this: It's too easy to draw a conclusion from a chart and too time-consuming to take a deep look at the fundamental business behind any stock. Yet a stock's past performance can't tell you anything about where it's going.

The same holds true for stocks that have really lousy-looking charts -- a nose-diving share doesn't tell you anything about a company's future. In fact, stocks that have suffered protracted falls may be the best opportunities out there, if the fundamentals say so.

For instance, looking at the five-year chart of soup-to-nuts maker Campbell Soup would make you queasy -- the stock lost about one-quarter of its value in early 2003. PepsiCo looked much better -- it topped the S&P during that time. PepsiCo's spinoff of its low-margin bottling group in 1999 helped maintain growth to keep it in the black.

But reforms at Campbell had already reversed the trend of declining net income in 2003 as the company refocused operations. These companies had very different historical charts, but by early 2003, each had the fundamental drivers in place for future growth, and both have since returned more than 50%.

Great stocks, great companies
A company's stock may be volatile even over extended periods, meaning that business fundamentals are a better gauge of future results than past stock performance. Take a gander at some companies with charts beating the pants off the market in the past five years:

Company

Past 5-Year
Performance
*

Abercrombie & Fitch (NYSE: ANF  )

81%

Terra Nitrogen (NYSE: TNH  )

3,649%

America Movil (NYSE: AMX  )

616%

Rio Tinto (NYSE: RTP  )

400%

Research In Motion (Nasdaq: RIMM  )

2,981%

* Data from Yahoo! Finance. Returns include reinvested dividends.

The stock gains of many of these companies can be tied back to fundamental business improvements. For instance, America Movil has averaged almost 40% annual revenue growth over the past five years, thanks to continued growth in its Mexican home market.

Research In Motion continues to defy threats from competing smartphones from Nokia (NYSE: NOK  ) and Apple. BlackBerry devices are flying off shelves around the world, even in a poor consumer climate in the U.S. The result is revenue and net income that has more than doubled year-over-year in the most recent quarter, leading to a double in the stock as well.

Regardless of past gains, these companies had the right stuff to go higher. Some of these names may continue to outperform the market going forward, but their past charts won't help you pick the best investment today. Fundamentals, however, will.

In addition to revenue, earnings, and additional financial measures, other underlying fundamentals in companies are worth evaluating. With retailers, investors should look closely at inventory management. With telecoms, they'll want to look at trends in churn and customer additions. And with all businesses, investors should look beyond just the numbers and feel confident in the quality of management decisions. These may be critical in identifying a stock at its peak versus one ready to go even higher.

The fundamental conclusion
With the current turbulence in the market, many stocks are tumbling from their highs. But this actually makes it a great time to invest, particularly in fundamentally sound businesses, not just those with impressive charts for who knows what reason. There's no guarantee how long a company's stock will keep rising, but investors can dramatically improve their chances of picking long-term winners -- and avoiding overpriced companies -- by basing decisions on business fundamentals, not just charts.

If you're interested in stocks driven by fundamentals -- and not just hype -- have a look at the Motley Fool Stock Advisor service. David and Tom Gardner watch the fundamentals of hundreds of companies and recommend them to readers when shares are priced for big gains. A free, 30-day tour of the full service, stock picks and all, is just a click away.

This article was originally published May 23, 2007. It has been updated.

Fool contributor Dave Mock thought his electric bill couldn't go any higher, either. He owns shares of Campbell Soup and Starbucks and is the author of The Qualcomm Equation. Apple is a Stock Advisor recommendation. The Fool's disclosure policy knits one, purls two.


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