7 Signs You've Found a Winning Stock

One of the major goals of my real-money portfolio is to introduce and explain the various screens I use to find great stocks. I'll be running each screen for you monthly. Plus, in pure Moneyball fashion, I am now tracking and scoring each one so we'll know exactly what's working and what's not. More on that in a moment.

In the batter's box today: my "7 Signs of a Winner" screen.

The windup...
This particular screen was born out of my work with Motley Fool co-founder Tom Gardner for the Motley Fool Hidden Gems service. Tom is always studying winning and losing stocks in order to learn how to better find the champions and avoid the dogs -- and I help him as best I can. A few years ago, we studied all of the Hidden Gems winners to find out what they had in common. We found that many of them shared these seven traits:

1. Double-digit rising sales: We view this as one of the most telling indicators of a real growth company. We love earnings growth as well, but earnings are too easily manipulated. Revenue growth, however, is a pretty pure marker of rising demand and pricing power.

2. Rising free cash flow and book value: While earnings can be fudged, cash is where it's at -- and great businesses generate lots of it. A company that's growing both its free cash flow and book value is on the right track.

3. Improving margins: The ability to take in more and more profit from each dollar of sales indicates competitive advantages and efficient management.

4. Rising return on equity: We use ROE as a decent proxy for how well a company allocates capital -- what Warren Buffett calls the most important aspect of management.

5. Insider ownership: This one's no surprise to all you veteran Fools out there. As shareholders of a company, we are part owners of the business, and we'd like a significant portion of management to be our co-owners. That way, there's more incentive for them to act in our best interests. We look for ownership of 5% or more.

6. Regular dividends: Research indicates that dividend-paying companies tend to be better at managing capital and growing earnings. We feel that the pressure of making quarterly cash payments forces a certain discipline on managers and deters them from such destructive habits as "empire building" -- that's when companies in search of something to do with their cash start making less-than-ideal acquisitions.

7. Out-of-the-way success: Many big winners come out of relative obscurity and are never media darlings or hot IPOs.

...and the pitch!
Armed with that information, the natural question to ask is: "How can I find companies that meet these standards?" Well, by screening, of course! Armed with my awesome Capital IQ screening tool, I looked for companies with more than $200 million in market cap that met the following criteria over the past 12 months:

  • Total revenue growth of 10% or better
  • Free cash flow growth greater than zero
  • Book value growth greater than zero
  • Net margin growth greater than zero
  • ROE growth greater than zero
  • Insider ownership at least 5% or better
  • Dividend yield greater than zero

The only thing I can't screen for is out-of-the-way success, but if I feel a stock is overhyped and overvalued, I won't consider it for my portfolio.

Of the 3,585 companies on U.S. exchanges with a market cap of $200 million or greater, only 36 passed the screen.

The list has something for nearly every type of investor. If you're looking for a high dividend yield, consider Main Street Capital (NYSE: MAIN  ) (7%) and Energy Transfer Equity (NYSE: ETE  ) (6.1%). Also, The Buckle's official yield is only 2%, but the company may yet again hand out a special dividend that could push its effective yield closer to 7% or 8%.

Value investors will find five stocks with forward earnings multiples under 10, led by Western Refining's (NYSE: WNR  ) 5.9 multiple. Universal Health Services, Cascade, Textainer, and RPC (NYSE: RES  ) also have single-digit forward P/Es.

For high-growth aficionados, bebe stores (Nasdaq: BEBE  ) is expected to boost earnings per share 163% annually over the next two years, from $0.14 per share in 2012 to $0.50 per share in fiscal 2014. Likewise, estimates have Cogent Communications going from $0.10 per share in 2012 to $0.84 in 2014.

Tracking time
Those are just a few of the 36 that passed the screen, but I'll post the full list on my discussion board. Also, every new company will be entered as a "buy" on the 7 Signs Motley Fool CAPS page, and those dropping off the screen this month will be "sold" in the CAPS account. That doesn't represent the way we would normally buy and sell stocks; you can see that in my actual portfolio. But this methodology should let us use CAPS to give us an idea of the effectiveness (or lack thereof) of the screen.

Besides the high yielders I mentioned here, you can find a few more that our analysts are excited about in our special report, "Secure Your Future With 9 Rock-Solid Dividend Stocks." It's yours free -- just click here.

Fool analyst Rex Moore tweets but is not a twerp. He runs a real-money portfolio based on his screens. He owns no companies mentioned here.

The Motley Fool owns shares of Western Refining and Buckle. Motley Fool newsletter services have recommended buying shares of Textainer. The Motley Fool has a disclosure policy. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.


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  • Report this Comment On July 06, 2012, at 11:38 PM, MrSinnister wrote:

    When will Discovery Labs (DSCO) finally get some love ? I mean they have 2 FDA approved products that go into distribution in the 4Q, with the FDA approval coming in March. They only have 43 million outstanding shares, with a current market cap of 125M which nearly multiplies with every 10 cent increase. They are going to distribute a drug for Respiratory Distress Syndrome for infants in the US and European markets, and they have TREMENDOUS upside, already up 60 percent on the year. Add to that two more drugs awaiting approval, Aeroserf, that is in a collaboration with Batelle to get streamlined and fine-tuned and Surfaxin LS, a liquid version of their already FDA-approved drug Surfaxin. How this stock stays in the 2 range is amazingly shortsighted.

    Value of Surf LS + Afectair: 275million

    Shares O/S: 43mil

    Tell me why we can't see $40+/share with DSCO. Note that my sell target is below this, but I expect the stock to soar once it gains momentum. Imagine that liquid surfaxin penetrates the market quickly and gets great reviews by practicing docs (which it should). Surf LS will be even better. And Aerosurf even better after that.

    Facts:

    1. one approved device

    2. one approved drug

    3. $40 million in cash

    4. no debts

    5. no preferred stocks

    6. no impending warrants (outside of the 5yr 5M at 2.80)

    8. exclusive rights

    9. excellent pipeline

    10. Newly partnered (Batelle for R&D)

    11. MAA approval soon

    12. New device new drug launch soon

    13. Mkt Cap 128 million ???

    At 3 times sales, this is already $400 million firm, and that is $10 PPS. DSCO === Hidden Gem.

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