#1 Big Profit Growth Creates Market Gems. IBD's 20 Rules: An Investor's Corner Series First In A Series Sometimes trying to follow the rules can be a wrestling match. Take the No. 1 rule in "IBD's 20 Rules for Investment Success:" "Consider buying stocks with each of the last three years' earnings up 25%. " (Click here to see the entire list.)
There are times when even that, the most basic of rules, seems impossible. Take March 2001, for example. Companies' annual track records had been battered, first by the tech crash of 2000, followed by the telecom sell-off and the Enron-led energy industry collapse. Then the attacks of September 2001 deepened the dent in company earnings across nearly every industry in the U.S. But scanning through IBD's Stocks In The News feature early that year, investors would have found Teva Pharmaceuticals (TEVA). The Israel-based company was already the world's largest generic drug maker. In the three years through 2002, earnings rose 29%, 55% and 39%. The stock had broken out initially in October. #2 Look For Top-Notch EPS, Sales Growth. IBD's 20 Rules: An Investor's Corner Series Second in a series Sometimes, good enough simply isn't good enough. Seek out stocks of those companies that have reported recent quarterly earnings and sales growth of at least 25% from year-ago levels.
Even better, seek companies that show growth of 40% or more. The true market leaders tend to post such increases ahead of their big price runs. This makes perfect sense. After all, you think you spotted a great stock of a great company. Why focus on big increases in both profits and sales? What were the company's results in its most recent quarter? Something is wrong. Higher profit may be the result of cost-cutting measures.
Now let's say earnings growth for the quarter is flat while sales surge 50%. Again, something is wrong. Years of research show the minimum you should see for sales and earnings growth in the most recent quarter is indeed 25%. But this doesn't mean you should settle for the minimum. But be real. So get the best ones. #3 The Best Stocks Show Great Margins. IBD's 20 Rules: An Investor's Corner Series Third in a series At the right price, most products will sell. Liquidation sales and garage sales testify to that. Yet, strong sales for a company aren't always good news. You should always look at revenue growth in the context of profit margins. If the only way a company can create interest in its product is by slashing prices, then that suggests that either the product has been commoditized or that the company has an inferior product vs. competitors.
The best companies make products or provide services that are so much in demand that strong profit margins are maintained while sales balloon. Analysts differ on whether they prefer to look at pretax margins or after-tax margins. Today we'll look at after-tax margins. There are four ways to evaluate after-tax margin. First, look for acceleration from quarter to quarter. Remember, the disciplined investor is looking for the strongest stocks, not a so-so stock. We studied a recent IBD 50 list. #4 Don't Be Fooled By A 'High' P-E Ratio. IBD's 20 Rules: An Investor's Corner Series Fourth in a series You hear it all the time: This stock has an amazing dividend, or that one's really cheap (meaning a low P-E ratio).
Don't be fooled into putting too much weight on these factors with your stock investing. Successful investors using IBD know not to do so. Instead, they focus on the strength of a company's growth, its institutional sponsorship, its competitive position in the marketplace, and the stock's price action. IBD's Rule No. 4 for investment success is to avoid buying a stock simply because of its dividend or P-E (price-to-earnings) ratio.
Certainly, it's worth considering the dividend and P-E ratio when you research a promising issue. But many investors focus far more on such metrics than they should, and you don't want to make that same mistake. The dividend, after all, comes from a company's profits. Big Growth Spurs Big P-Es But what about the P-E ratio? #5 Use Charts To See Sound Bases. IBD's 20 Rules: An Investor's Corner Series Fifth in a series In just about every task, you're going to need the right tool to get the job done correctly. Just as doctors and contractors have specific tools for their respective fields, investors have a wide array of tools with which to make key decisions. One of the most important tools: stock charts. Poring over financial statements, or trade journals can tell you what to buy, but they won't tell you when.
A stock chart is a vital picture of a stock's trading history. A company can have good fundamentals, but its stock may already be extended or is just not ready to move. IBD research has found at least seven price patterns or bases that, when cleared in heavy volume, can be the launching pad to big gains. Each pattern must conform to specific criteria. Sound patterns are generally early stage, have prior uptrends of at least 20% or 30% and have overall tight action.
Tenaris (TS) broke out from an 11-week flat base Feb. 2, 2005 1. IBD'S 20 Rules: #6 Cut Your Losses Short, Always. IBD's 20 Rules: An Investor's Corner Series Sixth in a series Among IBD's 20 rules for investment success, only one is the golden rule: Always cut your losses short. Always. If you're new to growth-stock investing, then you'll understand the value of this rule by the end of this column.
If you've been investing with IBD for a while, you know its importance. You've seen big leaders that peaked, then fall drastically. Why cut losses at 7% to 8%? IBD's research has found that if you buy a leadership-quality stock at the moment it breaks out of a sound base, and the market is in a healthy uptrend, the stock should not fall 8% from the proper buy point. It could briefly fall a smaller percentage. Cutting losses is like having disaster insurance. What if pride, ego or indecision prevents you from selling when a stock is down more than 8%? But what if you decide to dump a stock that's fallen 25%?
Things went wrong. "I saw it fall and yet I refused to face reality. IBD's 20 Rules #7 New America Keeps Tab On Innovators. IBD's 20 Rules: An Investor's Corner Series Seventh in a series An old rule of thumb among seasoned entrepreneurs holds that a successful product or idea is at least "15% new" compared to what's out there. One of IBD's top investing rules guides investors to sniff out that key 15%: invest in entrepreneurial companies. Pay special attention to ones that went public in the last five, 10 or 15 years. It's vital to find the "N" in the CAN SLIM investing mnemonic — companies with something new to offer, companies that are innovating toward new territory in their respective markets, companies whose markets have been shaken up and are in transition. Such companies are under constant review in IBD's New America section, today on Page A6. Another informative feature is the daily AfterMarket box just above the New America articles.
IPOs tend to be companies breaking new ground. Another breed of new issues are consolidators. More recently, much of the consolidation has centered around the Internet. #8 Institutional Buys Power Leaders. IBD's 20 Rules: An Investor's Corner Series Eighth in a series Follow the big money, and you'll get a handle on a stock's chances for success. You'd do very well to take note of a stock's increasing institutional sponsorship as a sign to take that stock seriously.
Without big-money investors such as mutual funds and banks, a stock will find great trouble putting up big gains. Those big guns account for the lion's share of daily stock-market volume. Did you think that it's the small investors that determine a stock's fate? Here's another tip: Some very smart people run those funds. They put their boots on the ground to find fast-growing companies. How can you tell what sort of sponsorship a stock enjoys?
Check the stock's Accumulation/Distribution Rating. But you can see far more detail if you wish. Call up Baidu (BIDU). In the box below you'll find the number of funds that own Baidu. What do you see for Baidu? But now look at the history: Some 991 funds held shares in last year's Q3. #9 'New' Is Key But Don't Overweight It. IBD's 20 Rules: An Investor's Corner Series Ninth in series The now-defunct Burger Chef once was on the cutting edge among hamburger chains. In the late 1950s, the Indiana-based company was the first fast-food chain to offer a combo meal, according to people who track such things. Later, the chain was the first to introduce a colorfully boxed children's meal with a free toy. Its Big Shef sandwich beat McDonald's Big Mac to the menu board by several years (and some Hoosiers still insist today that it was a better sandwich). Burger Chef also is believed to be the first fast-food chain to offer a works bar, where customers dressed their sandwiches to individual preference.
In 1968, Burger Chef was just a step or two behind McDonald's (MCD) torrid growth pace. Today, there are zero Burger Chefs and 33,000 McDonald's. What the heck happened? Ultimately, being first didn't matter. Seldom has there been a more one-sided outcome. IBD's 20 Rules #10 Keep Eye Out For New Management. IBD's 20 Rules: An Investor's Corner Series Tenth in a series Current GE chief Jeffrey Immelt once said that in the 1990s, a "German shepherd could have run GE. " In other words, it's not always that important who's in charge, such as during those boom years more than a decade ago. Talk about an iffy premise.
The fact is, leadership is critical at basically all times. Immelt's quote was featured in this column a year ago, but it's worth repeating because it's so wrong-headed. IBD-style investors should have the opposite idea in mind. With that in mind, one of IBD's 20 rules for investment success has to do with seeing if there's been a shift in a company's leadership. Rule 10 states: "Check out companies buying back 5% to 10% or more of their stock and those with new management.
" Priceline.com (PCLN) is a good example of a company that benefited from new management. The online travel company's stock was struggling in November 2002 when Jeffery Boyd became the firm's CEO. Grow, indeed. #11 High IBD Ratings Ensure Quality. IBD's 20 Rules: An Investor's Corner Series Eleventh in a series Finding fundamentally sound stocks showing strong price action can take hours of research. That's where IBD Ratings come in. Two key ratings, the Composite Rating and Relative Price Strength Rating, can help investors simplify their hunt for high-quality and top-performing stocks.
Investors should focus on stocks with a Composite Rating of 90 or higher and a Relative Price Strength Rating of 85 and up. IBD's Composite Rating combines several proprietary ratings into one gauge. More weight is placed on the EPS and RS Ratings. The Relative Price Strength Rating helps point you to market-leading stocks fast. Both ratings go from 1 to 99, with 99 being best. The CAN SLIM investment system is about buying stocks with top-notch fundamentals that are outperforming the market. Sticking to stocks with Composite and RS Ratings of 90 and higher and 85 is just a start. #12 Stocks On The Move Spots Winners. IBD's 20 Rules: An Investor's Corner Series Twelfth in a series Do you like stock tips? Well, it depends, right? If they're good, who would refuse?
Problem is, no one — repeat, no one — is capable of giving good tips every time. Meredith Whitney, the former Oppenheimer analyst who showed true courage when she wrote in 2008 that Citigroup (C) would ditch its dividend, may have gotten her call wrong on municipal bond defaults this year. If you want to learn how to fish for nice gains in the market, rather than receive a fish here or there, you need to have a reliable source of information showing which stocks possess uncommon strength and have the potential to break out to new highs. The Stocks On The Move table, printed most days on B1 and found on the home page of Investors.com, is one such source. Before a stock breaks out and makes a 20%, 50% or 200% run, it must first show it can rise substantially in heavier-than-usual volume. #13 Managers' Stake In Firm Is Key.
IBD's 20 Rules: An Investor's Corner Series Thirteenth In A Series "Owner-operated" is always a good sign, whether stenciled on a big-rig truck or a leading stock. In either case, it means those at the controls have a higher-than-usual interest in piloting the vehicle safely and profitably. In stocks, there are a number of ways to track down the percentage of outstanding shares owned by management. The company descriptions in the Weekly IBD 50 lists include percentage of management ownership.
The Big Cap 20 list also shows management ownership. You can also find management ownership data using the E-Tables tool at investors.com. Management held a 31% piece of stun gun maker Taser (TASR) when it started its epic run in April 2003. This is not to say that companies with lesser management ownership don't do well. So as you line up your pluses and minuses in fundamental research, don't ignore this factor, which suggests management is thoroughly vested in seeing that share prices do well. #14 Cheaper Isn't Better. IBD's 20 Rules: An Investor's Corner Series Fourteenth In A Series "The Canadian and Denver markets list many stocks that you can buy for only a few cents a share.
I strongly advise that you avoid gambling in such cheap merchandise, because everything sells for what it's worth. " So wrote William O'Neil, IBD founder and chairman, in "How to Make Money in Stocks. " Indeed, stocks trading below 10 or 15 per share are cheap. O'Neil cites his research into 125 years of stock-market history. Even now, with the market just starting to wobble after a three-year run, how many high-quality stocks can you name that are trading at 12, let alone 8 or 5? Certainly, some penny stocks go on to do very well. But the odds are against you from the start. And what of those few that become superstars? The stocks you should be seeking will show earnings and sales that far outstrip almost all others. What was the most expensive stock on that list?
Rule No. 15: Don't Invest Like A Central Planner. IBD's 20 Rules: An Investor's Corner Series Fifteenth In A Series A free-market economy and IBD's investment approach have something in common. The economy is comprised of millions of consumers and businesses making billions of decisions. No central planner, no matter how well-educated, can get a grip on enough of that diffused and fast-changing knowledge to offer intelligent guidance. That's why central planning inevitably fails. What does this have in common with IBD's investment approach? You have the same choice. Much of IBD's message revolves around listening to the stock market and reacting accordingly. IBD-style investors and free-market economists share something else. Humility is essential because no one knows when a falling stock will bottom. This is where Rule No. 15 comes in: "Don't try to bottom guess or buy on the way down.
Let's break down Rule No. 15 into its pieces. • Don't try to bottom guess: The disciplined investor knows this is folly. Rule No. 17: Raise Cash If Big Selling Emerges. No. 18 You Can Time Your Market Entry. #19 Small Caps Or Big? Track Indexes. #20 Post-Trade Analysis Will Help You. #16 Get Out While The Getting Is Good.