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:

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

Did you buy any of these before they soared several hundred or thousand percent? That's what I thought. Go ahead and kick. 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 packed with 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. Not until much later did I figure out not only how to find more great companies, but how 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 (EV) of the company with its growth prospects.

These are all traits of the Hidden Gems team's philosophy. Its success is evident in Tom's pick of leading Chinese travel bookings provider Ctrip.com. Though it was a young company in high-growth mode, Ctrip.com was debt-free and had positive cash flow. Since the original pick in December 2005, the stock has returned 72%.

The current market presents a unique opportunity. Small-cap companies have been crushed lately, giving investors a better chance to buy into some of tomorrow's greatest companies at low prices. But risks and volatility still remain, making it even more important for investors to seek solid businesses, rather than simply chasing cheap stocks.

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. Chesapeake Energy is a Motley Fool Inside Value pick. Copart and Apple are Stock Advisor selections. Ctrip.com is a Hidden Gems recommendation. The Fool owns shares of Copart. The Fool has a disclosure policy.