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'ves. 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:

Did you buy any before they soared several hundred or thousand 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 soaring share prices -- 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. Then I realized I was doing a number of things completely wrong.

If you were to look inside my brain at the time, here are the rules you would have found governing my investing strategy (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 in which I invested 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 shouldn't 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 investing in fundamentally strong businesses -- companies that create value for their customers and shareholders -- is the best way to drive exceptional returns.

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

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

1. I started looking for high-quality, unknown companies with low market capitalizations (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 valued the stock by comparing the enterprise value of the company with its growth prospects.

All these are traits of the Motley Fool Hidden Gems team's philosophy. Its success is evident in Tom's 2003 pick of safety equipment manufacturer Mine Safety Appliances. The company was sporting high insider ownership of 25% and growing revenue. The stock was cheap four years ago, valued at only 10 times the free cash flow, and the stock returned 125% before Tom recommended selling late last year to look for even better opportunities.

My record has been improving as well. For instance, comparing enterprise value to growth prospects helped me see value in Starbucks shares in 1997 and Garmin in 2002. The leading coffee seller is up more than 400% since, and the leading GPS device maker is already an eight-bagger.

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

This article was originally published on July 18, 2006. It has been updated.

Fool contributor Dave Mock still kicks himself occasionally, but much less often. He still owns shares of Starbucks and Garmin, which are both Stock Advisor recommendations. Amazon.com is a Stock Advisor recommendation, too. A longtime Fool, Dave is the author of The Qualcomm Equation. The Fool has a disclosure policy.