Early Signs of Winning Stocks

We've all done it -- some of us repeatedly. Some of us habitually.

You know what I'm talking about -- kicking yourself. One of the oldest pastimes born from utter self-discontent and a strong case of the "should haves." In this case, I'm talking about applying a boot to your rear end for not buying a monster stock you spotted but failed to buy years ago before it rose 10, 50, or even 100 times in value.

Still don't know what I'm talking about? Look at the 10-year returns for these companies:

Company	10-Year Return
Hansen Natural (Nasdaq: HANS)	15,310%
Celgene (Nasdaq: CELG)	5,665%
Chico 's (NYSE: CHS)	4,900%
American Eagle Outfitters (Nasdaq: AEOS)	2,563%

Did you buy any before they soared several hundred percent? That's what I thought. Go ahead and kick now. I'll wait.

Which way to the ground floor?
Before I came to the Fool, my backside was so sore from the kicking that I couldn't sit at the computer. I was constantly chasing stocks. Every hot company that came on my radar would have share prices soaring until the exact moment I bought the stock. I was hunting desperately to get in early on a great company, but this goal eluded me until I realized a number of things I was doing completely wrong.

If you were to split open my head at the time and pull out the quotes that best characterized my investing approach, here's what you'd see (and why they worked against me):

1. "If so many people are talking about this company, it must be a winner!"
By following what every other Joe Investor talked up, I was missing a large trove of quality stocks that packed potential. The popular party stocks I invested in were often high on hype and low on substance, setting me up for big losses.

2. "The stock price doesn't matter -- this company's got unlimited potential!"
Every time I failed to recognize that a stock was insanely overvalued, I found out the hard way. Price does matter, and good investors know that there are prices they should not pay even for the best companies.

3. "Getting in on the greatest stocks is the best way to maximize my returns!"
Basically, I was too busy analyzing stocks to invest in businesses. I overlooked the fact that what really drives exceptional returns is investing in fundamentally strong businesses that create value for their customers and shareholders.

These faulty notions led me to either buy poor companies or good ones well after they had risen substantially in value. It wasn't until much later that I figured out how to not only find more great companies, but to invest in them before they rose dramatically.

Reform thyself
Following the lead of Tom Gardner with his approach to finding killer stocks early in the Motley Fool Hidden Gems newsletter, I turned over some new leaves:

1. I started looking for quality companies with low capitalization (typically less than $1 billion).
2. Rather than looking at beta values and momentum signals, I looked for companies with strong insider ownership, robust financial results (profits and cash flow), and evidence of solid management.
3. I focused on the enterprise value of the company versus growth prospects to determine an appropriate stock price to buy shares.

All these are traits of the philosophy that the Motley Fool Hidden Gems team employs. Evidence of its success is in Tom's 2003 pick of Middleby (Nasdaq: MIDD), a little-known maker of commercial cooking equipment for restaurants. The company has high insider ownership and was valued attractively compared with what the business was turning out in cash flow. Buyers back then have been treated to total returns of 363%.

My record has been improving as well. For instance, looking at enterprise value versus growth prospects helped me see value in Starbucks (Nasdaq: SBUX) shares in 1997 and Garmin (Nasdaq: GRMN) in 2002. The leading coffee seller has been a 10-bagger since, and the leading GPS device maker is already a triple.

If you're looking to improve your chance of spotting early signs of winning stocks, a subscription to Hidden Gems is a great way to do it. It includes a watch list full of great stock ideas and a wealth of analysis. Or you can try out the full Hidden Gems service with a risk-free 30-day trial by clicking here.

Fool contributor Dave Mock still kicks himself occasionally, but much less often. He still owns shares of Starbucks and Garmin, too. Starbucks and Garmin are Stock Advisor picks. A longtime Fool, Dave is author ofThe Qualcomm Equation. The Fool has adisclosure policy.