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

Frontier Oil (NYSE: FTO  )

1,036%

Comtech Telecommunications (Nasdaq: CMTL  )

1,137%

Pool Corporation (Nasdaq: POOL  )

510%

PotashCorp (NYSE: POT  )

828 %

Jos. A. Bank (Nasdaq: JOSB  )

1,188%

Suncor Energy (NYSE: SU  )

509%

Rio Tinto (NYSE: RTP  )

202%

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

And these returns include drastic drops in many of these stocks this past year. For instance, Frontier Oil is down almost 70% from its 2007 peak, but over the past ten years it has still far outpaced the market average. Had you jumped on any of these early, though, 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. 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:

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.

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 are giving 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. For instance, Tom Gardner recommended leading Chinese travel bookings provider Ctrip.com to subscribers in December of 2006. Though it was a young company in high-growth mode, Ctrip.com was debt-free and had positive cash flow. Since then, the stock has doubled.

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 no shares of companies mentioned here. The Fool has a disclosure policy.


Read/Post Comments (2) | Recommend This Article (4)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On April 20, 2009, at 4:33 PM, jknock625 wrote:

    Dave,

    Why do you post this kind of foolishness? First, nobody will buy and hold a stock over a 10 year period when the issue is showing these kinds of growth numbers - they will have taken profits long ago in search of the next big hit. Second, anyone with enough financial savvy to spot one of these winners would have "unhidden" the hidden gem. Third, anyone with enough funds to make significant investments would have certainly diversified and not put all their eggs in a single small-cap stock. I'm certainly not going to kick myself for missing out if guys like Buffet and Soros aren't doing the same. I've seen this same article in one form or another appear periodically on the Fool for about 5 years now - isn't it time to move on?

  • Report this Comment On April 23, 2009, at 10:40 AM, davidjon13 wrote:

    jkn,

    I'm not all that enthusiastic about this article either, but I'm afraid that I can't agree with everything you say.

    "First, nobody will buy and hold a stock over a 10 year period when the issue is showing these kinds of growth numbers - they will have taken profits long ago in search of the next big hit."

    Depends who. I haven't been holding any of the stocks mentioned here for 10 years, but I've been holding POOL for almost 9. I don't have a 500% return from it, but under the circumstances, 79% isn't bad either.

    "Second, anyone with enough financial savvy to spot one of these winners would have "unhidden" the hidden gem."

    I have been investing for about 10 years, and still have a significantly positive ROI - unlike the S&P 500, if I'm not mistaken. And I indeed spout my opinions on investments all over the 'Net, just like I'm doing right now; my gems stay hidden, though, because noone listens (as far as I know).

    "Third, anyone with enough funds to make significant investments would have certainly diversified and not put all their eggs in a single small-cap stock."

    Indeed, my investments are and always have been diversified, which is one of the reasons why my returns are still significantly positive. But they do include some small-cap stocks, so it's useful for me to read about them, even if I don't put all of my eggs in any one of them.

    Good luck.

    D.

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