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 that you spotted 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

Chico's (NYSE: CHS  )

213%

Hansen Natural (Nasdaq: HANS  )

5,658%

Celgene (Nasdaq: CELG  )

4,617%

Arcelor Mittal (NYSE: MT  )

258%

UnitedHealth Group (NYSE: UNH  )

432%

XTO Energy (NYSE: XTO  )

4,703%

Returns from Yahoo! Finance, factoring in dividends and splits.

And these returns include drastic drops in some of these stocks this year -- some even more than 60%. Had you jumped on any of these early, you'd probably be feeling much better about the current market conditions. 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 and hunting desperately to get in early on a great company. Then I realized I was doing a number of things completely wrong.

If you were to look inside my brain at the time, these would have been some driving principles of my investing strategy -- and the reasons they worked against me:

1. "Everyone's talking about this company, so it must be a winner!"
By following what every other Joe Investor talked up, I was missing a large trove of quality stocks packed with potential. The popular party stocks in which I invested were often high on hype and low on substance, and that set 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 busy analyzing stocks rather than investing in businesses. I didn't see that investing in companies that continuously create value for their customers and shareholders was (and is) the best way to drive exceptional returns. This has become even clearer in today's market environment.

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

Reform thyself
Now more than ever, there are great prices on fundamentally strong companies, particularly small caps. To improve your chances of getting in early on some of tomorrow's greatest growth stories, consider this approach:

  1. Start 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, look for companies with strong insider ownership, robust financial results (profits and cash flow), and evidence of solid management.
  3. Value a stock by comparing the enterprise value (EV) of the company with its growth prospects. In today's decelerating economy, trailing P/E values are often bogus indications of value.

The analysts at the Motley Fool Hidden Gems newsletter are especially excited about the opportunity to nab some small, strong performers at bargain-basement prices today. Small-cap companies have been crushed lately and given investors a better chance to buy into some of tomorrow's greatest companies at low prices. But risks and volatility still remain, so it's even more important for investors to seek solid businesses, rather than simply chase cheap stocks.

Getting in early on a solid company can make up for a lot of blunders along the way, too. I was surprised to find that my investment in Starbucks (Nasdaq: SBUX  ) -- which has had a harrowing 70% drop in the past two years -- is still a double for me and has far outperformed the S&P over the past decade.

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 so. It includes a wealth of analysis and a watch list full of great stock ideas. You can even 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 owns shares of Starbucks. UnitedHealth Group and Starbucks are Inside Value picks as well as Stock Advisor selections. The Fool owns shares of UnitedHealth Group and Starbucks and has a disclosure policy.


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