Finding great stocks can be a daunting task. While many investors are happy letting a financial adviser select their stocks, others rely on tips they read in magazines or on the Internet. Given the amount of market volatility day to day, picking promising stocks seems more like a matter of luck than the result of any real due diligence.
But this doesn’t have to be hard. In fact, finding stocks that will outperform the market is much easier if you keep three principles in mind…
Good Companies Earn Money Reliably
At the end of the day, successful companies earn money year after year. Now, one of my favorite metrics I use to find stocks is a high return on invested capital (ROIC). ROIC is calculated by subtracting taxes from operating profits and dividing the result by invested capital.
[ad#Google Adsense 336×280-IA]ROIC makes a superior metric because it is a more consistent measure of profits than net income. Additionally, ROIC excludes non-GAAP tricks like using one-time charges and write-offs that muddy the accounting waters.
So what’s a good ROIC reading?
Well, good companies generate a ROIC greater than 10% annually. But really good companies have an ROIC of 20% or more over a period of five or ten years. These companies are the exceptional ones that rightly belong inside a quality portfolio.
Better yet, companies with a consistently high ROIC perform better — growing twice as fast as the overall market.
Growth Is Important, Too!
There’s more to finding great investments than just buying stocks with a consistently high ROIC — consistent growth matters, too.
What this means is that we want to see increases in three areas: corporate revenues, free cash flow, and gross margins. Now, growth in each of these metrics over the past five years assures investors that the company isn’t losing its edge by growing at the expense of its profits.
The benefit to investors of combing ROIC and growth metrics is spectacular. Companies that meet both requirements crush the overall market by a wide margin. In fact, since 1997, stocks with consistently high ROIC and growth metrics quadruple the returns of the S&P 500.
And that’s no accident. Applying the right metrics is critical to finding great stocks.
Lastly, Buy Stocks On The Cheap
One of the biggest mistakes many investors make is buying stocks after a large gain in the fear that they’ll miss further gains.
But more often than not they find stocks that are overpriced and continue to underperform. Now, we all know that the market, as a whole, is over-priced. The Trump rally that started in November has stretched valuations beyond any reasonable level.
In fact, the S&P 500 average price to earnings ratio (P/E) is a fat 26.28. When compared to the historic mean of 15.6, stocks are definitely not cheap.
But remember, you’re not buying the whole market. You’re looking for individual stocks that have a consistently high ROIC and positive growth metrics. And when applied to my third principle, buying cheap, the results are astounding.
To identify these companies, I look for two things:
— Price to free cash flow (P/FCF)
— Enterprise value/earnings before interest, taxes, depreciation, and amortization (EV/EBITDA)
Price To Free Cash Flow (P/FCF)
Free cash flow is money left over at year’s end. A company can use it for just about any reason at the discretion of the board of directors.
Calculating the price to free cash flow ratio is important because it looks at the amount of cash a company generates. And because this ratio can’t be faked using non-GAAP accounting tricks, it provides a solid way to value a stock.
Here, I like to look for stocks with P/FCF ratios up to 14. Historically, stocks with ratio levels of between 0 and 14 produce the best results — with an average return of over 17% annually.
Many experts believe EV/EBITDA is the best ratio for determining value. This ratio is far superior to the P/E ratio, which ignores a company’s debt.
EV/EBITDA provides a theoretical takeover value for a company. Here, we’re looking for ratios below 10 — although many value investors prefer ratios below seven.
Thankfully, finding the ratio is easy: you can find it on the Yahoo! Finance ‘Key Statistics’ page for each stock.
Putting It All Together
The chart below illustrates the benefits of combining the three principles…
The graph shows that $1,000 invested in the S&P 500 in 1997 would have grown to $4,200. But buying stocks with a high ROIC grows that same $1,000 to $7,200.
But wait, it gets really interesting here…
By adding growth stocks in combination with high ROIC stocks, the $1,000 grows to more than $15,000 over the same period. Finally, a $1,000 investment in stocks that apply all three principles at the same time grows the investment to more than $51,000.
And that’s the kind of growth that can make someone a world-class investor.
Risks To Consider: As in every area of investing, past results do not guarantee future results. Each company meeting the requirements described above may not be able to continue doing so in the future due to market and economic risks.
– Richard Robinson
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