The Rally's Not Over for These Stocks

After more than a year, the rally that has pulled stocks from the brink of oblivion seems too good to be true. Yet even if the overall stock market may seem overdue for a correction, a closer look at certain individual stocks shows that at least some of the astronomical gains we've seen since early 2009 are fully justified by improving fundamentals.

Getting ahead of itself?
Pretty much since the rally began, many questioned whether the market's advance made any sense. Last year, the economy's recovery seemed anything but certain, as continuing high unemployment, stagnant to falling home prices, and other troubling developments on the economic front lined up to create uncertainty and doubt about the future.

In addition, some looked to the stocks that were benefiting most from the rally and concluded that they were predominantly "junk" stocks -- companies that had fallen the furthest and were therefore experiencing gains not because of any inherent improvement in their businesses, but rather because fears of bankruptcy had turned out to be overstated. Meanwhile, more stable companies tended to lag behind in their gains, despite being arguably more attractive from the standpoint of long-term investors.

A year on, though, we've had time to get used to the reality of the situation. As it turns out, most of the worst fears from last year didn't come to pass -- and many of the companies whose stocks have risen dramatically have encountered a strong recovery on the business front as well.

Results behind the recovery
Whenever stocks rise strongly, the concern is that those gains are unsustainable. What you'd really prefer to see when a stock goes up is to see its financial results rise along with it. That way, its relative valuation stays more or less constant, suggesting that the stock's rise is completely justified by improving business conditions for the company.

So to find good prospects for investors looking for places to put their money, I looked through some of the best-performing stocks to figure out which ones also had similar levels of earnings growth. In addition, to avoid any concerns about whether reported earnings were realistic, I also looked for growth in free cash flow.

Here are some of the stocks I found:

Stock

1-Year Return

1-Year EPS Growth

1-Year Free Cash Flow Growth

Sears Holdings (Nasdaq: SHLD  )

124.6%

377.6%

228.9%

priceline.com (Nasdaq: PCLN  )

201.3%

164%

43.3%

Limited Brands (NYSE: LTD  )

180.5%

109.9%

136.1%

Amazon.com (Nasdaq: AMZN  )

79.5%

36.7%

115%

Google (Nasdaq: GOOG  )

58.4%

53.3%

162.1%

Ross Stores (Nasdaq: ROST  )

51.4%

52.3%

124.5%

Source: Capital IQ (a division of Standard and Poor's); Yahoo! Finance. EPS growth excludes extraordinary items. Free cash flow figures represent unlevered free cash flow.

As you can see, a simple look at these growth rates doesn't give you a complete picture of what's going on with these stocks. In many cases, higher earnings growth hasn't translated equally to better cash flow. With others, cash flow has increased substantially, but it hasn't shown up as strongly in the company's GAAP accounting for earnings. If you have to pick, I'd much prefer to see actual cash flow rather than the accounting tricks reflected in earnings -- but the ideal investment would give you respectable numbers in both categories.

Also, keep in mind that screening for positive growth can leave out promising companies that have reversed earlier losses. For instance, Starbucks (Nasdaq: SBUX  ) didn't show up on my initial screen results. That's because despite the fact that it had strong earnings growth, its cash flow went from a negative to a positive number, making its cash flow "growth" a non-meaningful number. By these measures, though, it's safe to say that Starbucks would also deserve a closer look.

You're not too late
Given that the stock market has risen so much so quickly, many investors figure that there must no longer be any good values in the market. But what these results show is that at least for some stocks, improving profits and cash flow have kept pace with their rising share prices.

Stocks like these arguably give you the best of both worlds. If you believe the economic recovery is just now taking hold, then it's entirely possible that we've only seen the beginning of the good times for these stocks. On the other hand, even if the recovery proves to be muted, at least these companies haven't relied solely on future hopes to justify their gains. That kind of win-win scenario is exactly what every investor hopes to find.

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Fool contributor Dan Caplinger has been skeptical of the rally for a while, but he's still in the market. He owns shares of Starbucks. Google is a Motley Fool Rule Breakers choice. Amazon.com, priceline.com, and Starbucks are Motley Fool Stock Advisor recommendations. Try any of our Foolish newsletters today, free for 30 days. The Fool's disclosure policy is never-ending.


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