You've heard that speed kills. That's bound to be true if you're driving the Indy 500 blindfolded. But when it comes to stocks, speed is often good -- especially if you're talking about accelerating sales.
Allow me to elaborate. Sales increase when they rise year over year. For example, I just reported that 1-800-Flowers grew sales 11% from 2004 to 2005. Pretty solid, eh? What's more impressive is that from 2003 to 2004, sales grew only 6.8%. Thus, 1-800-Flowers is accelerating revenue growth.
What's that smell?
An even better situation occurs when accelerating sales lead to better margins, as was the case at Parlux Fragrances (NASDAQ:PARL). Fellow Fool Bill Mann was pretty dubious about this perfume maker in the summer of 2003. I can't blame him. Certain fishy insider transactions smelled rotten. Bill still wasn't impressed last spring, when the company introduced its new Paris Hilton line. But by December, Fool contributor Jeremy MacNealy found that the company was, in fact, accelerating both sales and gross and operating margins. Have a look:
| Metric | 2005 | 2004 | 2003 |
|---|---|---|---|
| Sales | $100,361* | $80,581* | $72,254* |
| Gross margin | 54.8% | 50.8% | 50.4% |
| Operating margin | 17.4% | 12.8% | 8.0% |
The stock is up more than 50% since Jeremy's discovery.
When you don't have enough information
Of course, Jeremy's analysis took into account much more than just sales and margins. He also noticed Parlux's improving balance sheet, for example. But what if you don't have anything else? What if you're trying to examine the prospects of a company that's yet to reach profitability? That was the situation when I first dug intoMotley Fool Rule Breakers recommendation Akamai Technologies (NASDAQ:AKAM) in December 2003.
Back then, I suspected that Akamai would ultimately throw off tens of millions in cash flow because of its highly leveraged business model. For the uninitiated, Akamai has a global network of thousands of servers that accelerate the delivery of content over the Web. The upfront cost of building that network was in the hundreds of millions of dollars. And that led to massive depreciation costs that dealt a heavy blow to operating and net income.
Investors weren't enthused. The stock languished in the single digits for most of 2002. Yet I reasoned that the servers had extraordinary capacity and that, ultimately, Akamai would be able to add new customers for very little money. That newer, high-margin revenue, then, would create an ample of supply of free cash flow. My thesis was grounded in accelerating sales from the prior four quarters, and two years of improving gross margin. Have a look:
| Quarter | Sales | Gross margin | Operating margin |
|---|---|---|---|
| Q3 2003 | $41,767* | 58.1% | -2.7% |
| Q2 2003 | $37,759* | 47.2% | -27.2% |
| Q1 2003 | $36,564* | 39.5% | -11.8% |
| Q4 2002 | $35,352* | 32.8% | -146.3% |
| Q3 2002 | $35,375* | 14.3% | -119.1% |
| Q2 2002 | $36,322* | 13.1% | -103.6% |
| Q1 2002 | $37,927* | 17.6% | -134.6% |
|
Q4 2001 | $37,110* | 8.7% | -164.8% |
By December, I thought Akamai was no worse than a quarter away from generating free cash flow. Turns out I was conservative. It happened barely two weeks after my initial coverage of the company appeared here at Fool.com.
A winning strategy
I'm hardly the only one to employ this strategy in searching for great stocks. Indeed, stock screens focusing on accelerating growth in sales, earnings, and cash flow are in abundance. (Don't believe me? Check out this one at MSN Money.)
My inspiration, however, remains the work done by McKinley Capital Management, a fund manager that handles portfolios for a wide range of clients. Tom Gardner first introduced us Fools to McKinley in the October 2003 issues of Motley Fool Hidden Gems. He wrote that McKinley had delivered outsized performance since 1988 by focusing on companies accelerating their earnings growth.
Its record has remained strong. For example, McKinley's small-cap growth fund has beaten the Russell 2000 index of small-cap stocks by more than 6 percentage points since its inception in 1997. I should clarify that McKinley tends to focus on accelerating earnings. But it's worth noting that accelerating sales often precludes accelerating earnings and cash flow. Witness Akamai.
Hit the gas
Most interesting to me is that McKinley's mechanical system has led it to buy and hold for its diverse set of portfolios several stocks from our Rule Breaker Universe. Among the list: Activision (NASDAQ:ATVI), Amgen (NASDAQ:AMGN), Google (NASDAQ:GOOG), IMAX (NASDAQ:IMAX), and Intermagnetics (NASDAQ:IMGC). We track these firms and others like them because they have helped reinvent the dynamics of their respective industries. Knowing that we're shopping in the same investing neighborhood as McKinley founder Robert Gillam is, frankly, very encouraging.
So is our record. The Rule Breakers portfolio has beaten the market by more than 9 percentage points over its short life. And, yes, we hope to accelerate those returns. Why not get in on the action? A risk-free trial to Motley Fool Rule Breakers is available to you for 30 days. That gives you access to the entire list of stocks we're tracking in the Rule Breaker Universe, our complete library of stock picks and related research, and private discussion boards where the quest for the next ultimate growth stock continues daily. And your satisfaction is always assured by our ironclad money-back guarantee.
So what do you say? Isn't it time to get out of the slow lane?
Fool contributorTim Beyershasn't been issued a speeding ticket in years. But that won't stop him from hitting the gas in his portfolio. Tim owns shares of Akamai. You can find out what else is in his portfolio by checking Tim's Foolprofile. Akamai is a Rule Breakers recommendation. Activision is a Motley Fool Stock Advisor recommendation. The Motley Fool has a disclosure policy.
