A Shortcut to Better Returns

There's nothing quite like the thrill of handicapping a horse race, confidently placing a bet, then watching your horse come thundering across the finish line well ahead of the rest of the field. True, wagering on a stock that appears poised to outpace its peer group can also get the adrenaline pumping -- but screaming at the shares to run faster won't make the slightest bit of difference.

While the sport of kings may be more pageantry than investing, the key to cashing winning tickets remains the same: Analyze the numbers, compare them with the odds that your fellow players have placed, and search for any risk/reward discrepancies that might have been overlooked. Of course, shareholders usually aren't rewarded in two minutes or fewer.

Whether it's stocks or horses, picking winners consistently is part art, part science, and part luck. However, my intention here is not to help you identify winners, but to rule out the most likely losers.

Eliminate the negative
I am by no means a handicapping pro, but I do consider myself a fairly astute student of the game. When assessing the possible outcomes of a race, my first step is not to circle the strongest horses in the field, but to cross out the weakest. By narrowing the list of potential contenders from say, 11, to just three or four, I can save time and devote the majority of my attention to the select few that have the best chance of reaching the winner's circle.

To isolate the realistic contenders, handicappers have many analytical tools at their disposal. Often, though, it's simply a matter of common sense. If a horse that has finished no better than seventh in nine career races is suddenly stepping up in class against better-quality competition and running at an unfavorable distance, then he's likely to be overmatched.

Unfortunately, spotting potential losers in the stock market is not always as simple (though it sure hasn't seemed that way over the past few weeks). Nevertheless, it is well-documented that companies with poor management, dismal operating performance, or excessive valuations usually stand little chance of outrunning their rivals over the long run.

By removing from consideration the long shots that score poorly in the following categories, you can narrow the pool of investment candidates to a much more workable number -- and save valuable time that would be better spent elsewhere.

1. Questionable management
Just as a horse is only as good as its jockey, a company is often defined by the quality of its leaders. Those with poor or untrustworthy executives are not worthy of your time or money.

Even a product that is almost universally loved couldn't keep shares of Krispy Kreme Doughnuts (NYSE:KKD) out of the fryer when it was discovered that corrupt management had concealed evidence of flagging sales and earnings.

Likewise, Fannie Mae (NYSE:FNM) lost nearly one-third of its value last year amid a high-profile accounting scandal. Apparently, the top brass manipulated the books to earn performance bonuses tied to earnings targets. New management is working to restore the company's reputation, but it won't happen overnight.

While there are dozens of similar examples, it's worth noting that management doesn't have to be fraudulent to cripple a stock -- it merely needs to be incompetent.

Inefficient use of retained earnings, for example, can be a quick way to destroy shareholder capital. Whether it's questionable corporate governance, overly generous compensation packages, or just off-the-mark decision making, all suggest that executives' interests are not necessarily aligned with those of the rank-and-file shareholders.

2. Poor track record
In horse racing, a track record is, well, self-explanatory. A slow horse with a string of last-place finishes probably won't become the next Smarty Jones -- so put your money to work somewhere else.

In the financial world, "track record" is a blanket term referring to practically anything that can be measured, from sales to earnings to gross margins to inventory turnover. Some industries will even have their own key metrics. For example, the best barometer of health for a retailer such as Children's Place (NASDAQ:PLCE) might be same-store sales, while shareholders of a hotel-management company such as Marriott (NYSE:MAR) might be keeping a close watch on revenues per available room, or RevPAR.

Regardless of the financial measure, reviewing a company's past performance can yield many clues. Some are obvious, such as whether a company has gained market share or expanded profit margins. Other signs are more intuitive, like a company's ability to maintain pricing power in a challenging operating environment.

In the case of greeting-card and gift manufacturer American Greetings (NYSE:AM), we can see that the company has been mired in a steady downward trend over the past several years.

Barring some type of catalyst, there is little reason to believe the company will bolt right out of the starting gate in fiscal 2007.

Of course, I'm not suggesting that companies with weak results are incapable of turning things around. Furthermore, automatically dismissing a troubled company without placing the results in context would be poor judgment. It could be an otherwise solid firm operating in a depressed industry, or suffering from a temporary cyclical slowdown.

However, those whose track records reveal deteriorating numbers and no foreseeable hope of improvement are usually better avoided.

Overvalued
At the track, whenever bettors pile heavily into an overwhelming favorite, they can force the odds down to the point where the horse isn't worth the gamble -- regardless of how strong the horse appears on paper. For example, I've seen some favorites run at odds of around 1-5 -- as opposed to long shots that might pay off at 60-1 or more. In the 1-5 case, a $2 win ticket would return only $2.40, hardly worth the risk.

The market is no different. Stocks that have attracted too much attention can quickly reach exorbitant valuations. It stands to reason that any time you pay more than $1 for a dollar's worth of fair value, any upside potential is limited -- even with stellar performance. At the same time, the least little stumble can disappoint investors and send the shares tumbling.

Over the past five years, Home Depot's (NYSE:HD) revenues have nearly doubled, from $45.7 billion in 2001 to $81.5 billion last year. Meanwhile, earnings per share have advanced at a rapid 20% annual clip over that same span. Yet the shares are trading lower now than they were at this point in 2001 -- approximately 25% lower.

Why the disconnect? There are several reasons to explain the slide, but one of the biggest is valuation. In 2001, Home Depot was trading at 44 times earnings and 41 times cash flows -- well above the broader market averages of 24 and 12, respectively. With those lofty expectations priced in to the shares, Home Depot has struggled to keep shareholders happy. (It probably hasn't helped that company CEO and chairman Bob Nardelli took home nearly $30 million in salary and bonuses last year, along with 590,000 stock options.)

Place your bets
So with the likely losers removed from consideration, all that is left is the simple matter of determining the winners. No problem.

In this regard, I prefer to do my own homework. I rigorously analyze performance statistics, trainers, track conditions, and other fundamental factors. Yet I'm not too proud to also seek the guidance of professionals. In other words, I sometimes consult a reputable tip sheet.

More often than not, these handicapping experts instructively point out factors of which I had been completely unaware. When they do, they more than earn the cost of their advice.

By the same token, you might want to flip through the pages of Motley Fool Income Investor before making another investment. Dividend guru Mathew Emmert helps pinpoint the market's thoroughbreds by focusing on companies with experienced management, attractive valuations, superior cash flow generation, and impressive track records of sustained dividend growth.

To date, Income Investor selections have raced out to an average gain of 11.7%, easily galloping past the S&P 500. Why not look over Mathew's shoulder and find out the names of nearly 70 of his favorite firms? He won't mind -- and it's free.

Fool contributor Nathan Slaughter once threw away a winning Pick 3 ticket by mistake. He owns shares of Children's Place but none of the other companies mentioned. Home Depot and Fannie Mae are Motley Fool Inside Value recommendations. The Motley Fool has a disclosure policy.