Spotting Stock Market Winners

Traders like to shoot for big wins and are willing to accept small losses along the way. In the stock market, big winners unfold over years and could be a valuable core holding in a trading account. Stocks can be traded on margin and many brokers allow traders to margin stocks, futures and options in a single account. Finding stocks that can offer steady gains may not seem appealing to the short-term trader, but the potential profits and diversification could make it a worthwhile endeavor. We’ll look at a couple big winners of the past to find lessons for the future and then fit that into a trading strategy.

An additional benefit of this idea is that with stock holdings, traders can reduce cash holdings. From the MF Global bankruptcy traders have learned that cash holdings have a significant degree of risk in some cases, which makes the use of margin even more attractive. No two financial crises are ever exactly the same, so the problems at MF Global will probably not recur in precisely the same way, but new and different problems will present new unknowns for traders in the future. Cash should probably not be held at a broker since the risks are unknown.

While the stock market has some volatility, the addition of futures strategies to the account should help steady the overall returns. Diversified strategies are an effective way to reduce risk. However, while futures strategies offer great potential returns, these markets are not suitable for all traders. Risk is greater in leveraged markets and without the ability to accept additional risk, traders should not use the futures markets. Traders could limit themselves to stocks, and long-term holdings could be the core of their portfolio. Short-term stock strategies can offer the benefits of strategy diversification.

The goal of trading is to grow the account balance over time, not to be right on any individual trade or make money over a short time frame. In the long run, stocks have been shown to deliver steady gains. While many studies use holding periods of 80 to 100 years or more to define the long-term, significant returns are possible over periods of less than 10 years. In order to hold a stock for that long, it would be important to buy the ones that have the greatest chance of success.

While trading usually relies heavily on technical analysis, long-term stock market winners usually have solid fundamentals. To some degree, this means that fundamental analysis is needed to spot potential stock market winners. Fortunately, there are a number of studies available that highlight the key variables to look at. Many studies agree that the price-to-sales (P/S) ratio is among the most effective fundamental ratios.

James O’Shaughnessy’s book, What Works on Wall Street, is being released with an update and is an exhaustive review of variables that can be applied to find winners in advance. In Quantitative Strategies for Achieving Alpha, Richard Tortoriello also reviews the factors that contribute to stock market success. Beat the Market: Invest by Knowing What Stocks to Buy and What Stocks to Sell by Charles D. Kirkpatrick, II, CMT, is yet another example of this type of research for those who are interested.

Since the P/S ratio is consistently cited as valuable tool, traders can screen for low P/S ratios as a starting point. The only other step in the fundamental analysis process would be to verify that sales are increasing. Over the long-term, changes in sales, earnings and stock prices are highly correlated. It is difficult to find a big winner that doesn’t increase sales, and the sales growth needs to be steady rather than spectacular. McDonald’s (MCD) presents an example of this concept.

McDonald’s has reported increases in global comparable store sales (a fundamental data point) for more than 100 months and the stock price has climbed steadily higher over that time. Overall sales growth has averaged about 5% a year during those 8.5 years, but the company has been able to compound earnings per share at a rate of 21.9% because it operates efficiently. The result has been a winning stock with annualized gains of more than 20%.

Another long-term stock market winner has been Hansen Natural (HANS). This company makes natural sodas and energy drinks and has delivered gains of more than 18,000% to investors over the same timeframe that MCD was a winner among large caps. Sales have increased more than 42% a year for Hansen allowing the company to grow earnings at more than 60% a year, and those factors seems to have been the drivers behind the jump in the stock price.

In studying stock market winners, fast sales growth is a factor that is common to the stocks that superstar mutual fund manager Peter Lynch called ten-baggers because you could make a 10-fold profit on your investment. Most of the really big winners started at a relatively low price, with HANS being about $5 a share (pre-split price) at the beginning of its run.

It is logical that the biggest stock market winners have generally started from low prices, often less than $5 a share. Bigger percentage gains seem to come easier for lower priced stocks. This does not mean that the biggest winners of the future are trading as penny stocks right now. Companies that trade as penny stocks often have no sales, and many do not maintain current regulatory filings. Penny stocks, generally meaning stocks that trade for less than $1 a share, should be considered a very speculative investment and are honestly unlikely to become long-term successes until they have a record of sales.

Traders looking for possible big winners should start with a simple screen of stocks that are low-priced and have recorded revenue gains in each of the past three years.

Margin requirements vary by broker, but some will require additional collateral for low-priced stocks. As one example, a broker may require you to put up 50% of the value of stocks you own if the price is over $5, but could require something like “the greater of 50% or $2.50 a share” for low priced stocks. You should check with your broker before screening for stocks. If they will not allow you to margin stocks trading for less than $5 a share, it might be best to screen for stocks priced between $5 and $10.

After creating a short list of possible buys, the next step should be to verify that the companies are current with all required SEC filings. It should take less than a minute to verify they have filed a quarterly report within the past ninety days and this is an added safety check that is very important if the stock is priced at less than $5.

The final step that is required in this process is to check the stock’s relative strength. You want to buy the strongest stocks. It is important to remember that Enron once had a record of sales growth and a low stock price but it was falling into bankruptcy and its stock price was headed towards zero. Adding a relative strength screen will help avoid buying the next Enron. This step would also have helped you avoid owning MF Global.

We can see the importance of relative strength by adding it to the chart of HANS.

Owning this big winner only when its relative strength rank was above 50 on a monthly chart would have captured almost all of the gains.

Relative strength rankings are available on a number of web sites and although each will be calculated in a different way, any one of them should be satisfactory for this approach. While weekly or daily rankings of relative strength can also work, using monthly data will help you to stay in the long-term winners for the greatest amount of time.

Finding stock market winners that can serve as core holdings starts with three simple screening criteria:

1. Price less than $10 (or some lower amount but usually above $1)
2. Sales growth recorded in each of the last three years
3. Relative strength rank greater than 50

Applying advanced analysis is optional, but these stock trades could be profitable and allow you to hold positions for several years at a time. When faced with multiple possible buys, select the ones with the lowest P/S ratio.

This simple analysis process frees up time to pursue short-term trading strategies. By applying strategies focused on different time frames, you should increase your chance of trading success.

By Michael J. Carr, CMT