Stok strategy
Course I -- How To Select The Right Stocks At The Right TimeIntroductionThe eleven lessons in this course explain the characteristics of successful stocks and the forces that push them up. The first seven lessons explain specific traits to look for when buying stocks. The eighth is a summary, providing you with a checklist for evaluating stocks. The ninth and tenth lessons offer instruction on how to read stock charts to give you the total picture before you make your purchase decisions. The final lesson explains how to monitor stocks once they're part of a portfolio.This course is based on the findings of a landmark study that identified the common characteristics of the best stocks before they made their major advances. You'll also learn how to use features in Investor's Business Daily and investors.com to check if a stock really has the characteristics of a winner.Search the FAQs for How to Buy Stocks • Earnings: The Indispensable Element Of Great Stocks The single most important gauge of a stock's potential is its earnings growth.• Sales, Profit Margins, Return On Equity These three fundamental factors are crucial in evaluating a stock. Learn what they mean.• Sponsorship: Catching The Stocks The Pros Are Buying When mutual funds and other professional investors buy certain stocks, the sheer magnitude of their buying power propels stock prices higher.• The Strongest Industries Often Produce The Best Stocks Up to half of a stock's price movement is influenced by the industry it belongs to.• Leading Stocks Are Leaders For A Reason How to identify the current stock market leaders. It is these stocks that provide the best opportunities for future gains.• New Price Highs Mean New Opportunities When a stock reaches a new high, it doesn't mean its best days are over. On the contrary, it's actually a good time to consider buying it.• New Products, Services Or Management Astounding stock gains don't just happen. Great new products, services or management teams are usually the driving force behind the greatest stocks.• Your Stock Buying Checklist: Sorting Through The Process Successful investing requires checking all the vital elements of a stock. This checklist tells you what you can't afford to ignore.• Chart Patterns Help You Spot The Right Time To Buy, Part I Charts help paint a picture of investor demand for a stock, revealing important clues about its prospects.• Chart Patterns Help You Spot The Right Time To Buy, Part II Any stock worth buying has a recognizable price and volume pattern you can learn to identify.• You've Bought A Stock—Now What? Buying a good stock is just part of the challenge. Learn how to protect your investment by knowing the best time to hold or sell your stock.1. Earnings: The Indispensable Element Of Great Stocks Research shows that earnings growth is the single most important indicator of a stock's potential to make a big price move. In this lesson, you'll learn how to find the companies with the best earnings growth and avoid some pitfalls that trick many investors. Assess Your Knowledge On This Topic Why Earnings Growth Is So CrucialHow many times have you kicked yourself for passing up a great stock like Microsoft or Home Depot? There were tell-tale signs that these winners were about to make major moves before they became household names.YahooYahoo surged 458% in seven months starting September 1998. Right before this phenomenal move, Yahoo reported three quarters of earnings growth of 1 400%, 500% and 800% - clear indications that this stock was building a strong track record and poised for further growth.MindspringMindspring surged 237% in five months starting November 1998. In the three quarters prior to this, it reported earnings growth of 140%, 233% and 800%, respectively.Brooktrout Technology Inc.Brooktrout Technology Inc., a maker of software and hardware for networks and telecommunications systems, catapulted 230% over 23 weeks starting in December 1995. The three quarters before this great move saw earnings growth of 31%, 47% and 100%.See a pattern here? A study of the greatest stock market winners dating back to 1953 looked at all the biggest stock winners - stocks that doubled, tripled, and even went up even more. This was a comprehensive study that analyzed every fundamental and technical variable. What emerged were seven common characteristics among the big winners with earnings growth being the most significant factor. (The other winning factors from the study are discussed in subsequent course lessons.)Three out of four companies averaged earnings increases of 70% or more in the quarter right before they started to make a huge price move.Three-quarters of these top stocks showed at least some positive annual growth rate over the five years before their major price move.This research continues today, and consistently confirms the original findings about the significance of strong earnings growth. The study also reinforces that under countless market conditions over the years, the selection criteria still work today when searching for winning stocks. When it comes to investing, start with a look at a company's quarterly and annual earnings record.Earnings, continued What Are Earnings?Earnings, also called profits or net income, are what a company makes after paying all its obligations, including taxes. Companies often conclude their quarters at the end of March, June, September and December, though some companies end their quarters in different months.Companies report their earnings in two ways: a bottom-line total and a per-share amount. The per-share figure is calculated by dividing the total earnings by the number of shares outstanding. Example: XYZ Corp., with 45 million shares, reports earnings of $35.8 million, or 80 cents a share. The per-share amount is most relevant for investors.Acceleration Is Also ImportantMany stocks that make major advances have another trait. Their earnings accelerate over the previous three or four quarters. Acceleration represents an increase in the earnings growth rate quarter over quarter.Shares of Cree Inc., the maker of semiconductor devices, were at $20 in May 1999 when it began an ascent that took it past $100 by early 2000. Before this jump began, its quarterly earnings grew 67%, 71% and 86%.Improving bottom-line growth, such as Cree's, nearly always precedes a burst in stock price. What's important to realize about this is that it's not just rising earnings that make a good stock. The key is to focus on companies whose earnings may be drawing professional investors' attention -- the phase when a stock prepares to spring higher. (For a detailed description of the importance of volume and institutional sponsorship, see "Sponsorship: Catching The Stocks The Pros Are Buying.") So, Here's What You Want To Look For When Researching Your Stocks:• Quarterly earnings-per-share growth of at least 25% over the 2 same quarter the year before. • Preferably, accelerating earnings in the three most recent quarters. • Annual earnings-per-share gains of at least 25% over the past three years. Strong companies with good management teams, innovative products and leadership in their industries boast the best earnings and reflect the best investing potential. Remember, in a good market, the opportunity of a lifetime stock can come along every two or three weeks. Evaluating EarningsUnless you have time to sift through endless earnings reports, odds are you'll miss out on those companies announcing superior earnings. And how do you know the difference between a one-hit wonder and a potential stock market winner when you are looking at raw earnings numbers on thousands of companies?Investor's Business Daily compares the earnings performance of all domestically traded stocks each day using its proprietary Earnings Per Share Rating. The EPS Rating measures each stock on a scale of 1 to 99 (99 being best) for a quick assessment. An 80 EPS Rating means that stock is outperforming 80% of all other stocks based on earnings growth. Seen another way, a stock with an EPS Rating of 80 is in the top 20% of all stocks in terms of recent quarterly and annual earnings growth. Our research shows that the stocks that make powerful gains usually have an EPS Rating of 80 to 85 or higher.The EPS Rating is found in the IBD SmartSelect® Corporate Ratings, a compilation of five financial-performance gauges on every stock that appears in the daily stock tables. The EPS Rating is found in Investor's Business Daily, Daily Graphs® and investors.com's IBD Charts, IBD Stock Checkup and My Stock Lists.(For Sample Purposes Only) To further evaluate and compare earnings performance, you can log onto Daily Graphs Online®. You'll find a menu of performance reports, including a list of the stocks with Top 100 EPS Ratings for both the New York Stock Exchange and the Nasdaq Stock Market.This is an example of a Daily Graphs Online® chart, showing earnings data in the upper left boxes and along the bottom.3 Click for full page image Stocks don't live on strong earnings alone. The performance indicators in IBD SmartSelect® Corporate Ratings help you round out the stock selection process. This set of tools also compares other meaningful factors, such as sales growth, return on equity, profit margins, industry vitality and a stock's price performance. (Subsequent chapters will go into detail about each of these factors.) Watching For PitfallsInvestors can easily be misled by popular myths about earnings.• Myth: You should buy stocks with low price-to-earnings (P-E) ratios. The P-E ratio is a comparison of the stock's price to its annual earnings per share. For example, a stock quoted at $50 a share with annual earnings of $5 per share has a P-E ratio of 10. In other words, the stock is selling at 10 times its annual earnings.Conventional wisdom says stocks with higher P-E ratios are overpriced and should be avoided. But the truth is that the best stocks often have high — some would say ridiculous — P-E ratios when they start their big climbs. And they continue having high P-Es throughout their advances.Studies prove the percentage gain in earnings per share over the year-earlier period had a greater impact on a stock's price.Would you have purchased these "high" P/E stocks?Stock P/E Ratio before advanceAmgen 300 (Up 650% in 22 months starting March 1990)America Online 205 (Up 557% in six months starting October 1998)Mindspring 157(Up 237% in five months starting November 1998)Ascend Communications 49(Up 1,380% in 15 months starting August 1994)MCI Communications 42(Up 266% in 17 months starting April 1988)4 If you weren't willing to pay the higher P-Es, you eliminated some of the best stocks of all time. • Myth: It's better to get into an unprofitable company's stock before the company turns around and other investors discover it. Again, studies tell you established companies that can't make much money for themselves can't make much money for investors. Even in late 1990s, when it seemed any stock with a dot-com name could surge without the slightest hint of profitability, a track record of good earnings growth still won the day. Research has shown most Internet stocks with earnings growth outperformed their counterparts posting losses. Corporate Earnings ReportsCompanies report their earnings every three months, and are widely disseminated soon after their release. Investor's Business Daily publishes a comprehensive list of the prior day's earnings reports, separating those posting earnings gains from those reporting lower results. The number of companies in each of these categories helps you get an overall idea of the profitability of U.S. corporations. The earnings table shows the percentage above or below analysts' consensus estimates, and arrows indicate whether there's been acceleration (up) or deceleration (down) in earnings or sales growth compared to the prior quarter. Any increase of 25% or better is boldfaced in the "EPS % Chg" column. The company's entire line is boldfaced when the EPS growth is more than 25%, the EPS Rating is more than 85 and the earnings were better than expected. (For Sample Purposes Only) When it comes to analysts' estimates, you want to see forecasts that represent positive indications of growth. But remember, these are only estimates, and they are no substitute for a track record of past performance. Daily Graphs includes earnings estimates.One other point: Investors should also be wary any time a company announces "record earnings." If you think about it, a company could be growing at just 2% or 3% and still have its best-ever quarter. You don't just want earnings to be better than the year before; you want to see remarkable gains.Key Points To Remember• Insist on the best earnings performance, not just a promise of earnings. This way, you will pick stocks with the best probability of making Yahoo-like gains. • Look for companies reporting earnings growth of at least 25% in the most recent quarter. • Find companies with earnings that have accelerated in the three or four most recent quarters. • Identify stocks with annual earnings growth of at least 25% over each of the 5 previous three years. • Focus on EPS Rating for a quick way to evaluate a company's earnings. EPS Ratings of 85 or higher are best. • Don't overemphasize the price/earnings ratio as a way to compare a company's stock relative to its earnings. 2. Key Fundamentals: Sales, Margins, Return On Equity Sales growth, profit margins and return on equity are vitally important in evaluating a company's health. This lesson explains the significance of these financial gauges and how to identify the companies with best numbers. Assess Your Knowledge On This Topic It All Starts With SalesSales figures are a key measure of a company's strength -- or lack of it. Perhaps no other piece of financial information reflects growth better than sales: the money that comes into a company from products sold or services rendered. If a company is run efficiently, sales growth essentially drives earnings growth. Companies basically have two ways to increase earnings. They either increase sales, reduce expenses or ideally do both. Although a well-managed company controls expenses, healthy sales are the main engine for growth.When you search for the best stocks, you want a company to have strong sales growth to support its earnings growth. Think of sales growth as the foundation under your house: if it is loose, it's not as stable as one with all the structural elements in place. When you see a company increasing its sales, it's telling you its business is drawing larger demand and is structurally sound and prepared to expand and generate the earnings capable of boosting its stock price.Demand is driven by a number of factors, including larger numbers of customers, customers increasing their purchase volume, introduction of new products, expansion into new markets and the improvement of existing products.The top-performing companies show consistent double- or triple-digit sales growth. It's even better when the percentage growth rate increases quarter after quarter. Such acceleration is the hallmark of quality growth companies. They reflect a well-managed organization. Take a look at some companies that have done just that:NokiaNokia began a 630% jump from March 1998 through December 1999 and continued rising into 2000 after the wireless-phone maker reported sales gains of 9%, 12% and 19% in the three quarters leading up to the big move. Earnings were rising sharply during this period, too. Home DepotHome Depot made a 698% move from June 1982 to June 1983. Its sales grew 104%, 158%, 191% and 220% respectively over the four quarters leading up to this major stock-price jump. 6 EMC CorpEMC, the maker of memory chips, rose 512% from September 1992 to October 1993 as sales in the four quarters before this huge move rose 30%, 46%, 54% and a hefty 267%. How high should sales growth be? The three most recent quarters should each have strong sales growth of at least 25% compared to their year earlier quarters. Otherwise, sales growth should be accelerating in the last three consecutive quarters. Investor's Business Daily's earnings reports include the sales figures for every company releasing its quarterly results. Up and down arrows show if sales are higher or lower than the previous quarter. Watch For Pitfalls In Sales FiguresSometimes sales numbers mask problems at companies. Companies may rely on just a handful of customers, and losing any of them may mean big trouble. Other companies are overly reliant on overseas markets, putting them at risk of bad economies or political strife abroad. Also, fluctuations in foreign-exchange rates can seriously dilute sales figures. Some companies, such as pharmaceuticals, get the bulk of 7 their sales from a few flagship products. If sales in these items falter, it could mean more trouble than if the overall sales drop. With retailers, additions of new stores increase the sales figures, even if sales at existing stores slow down. That's why retailers report total sales as well as same-store sales, to provide an apples-to-apples comparison. Another pitfall happens when companies include sales that haven't actually taken place. Orders that won't be shipped or paid until weeks or months later sometimes are added to the sales total to inflate results.Profit Margins: Another Way To Assess Earnings PerformanceProfit margins are the portion of a company's sales that end up as earnings. As an investor, look for companies that generate an increasing percentage of profit out of every dollar of sales. The larger the margin, the better a company is at managing and leveraging its business.Studies of the greatest winning stocks revealed that most showed strong and even expanding profit margins before they made huge price moves. The best small and midcap stocks of the 1996-97 period had after-tax profit margins, on average, of 10% in the two quarters right before they made their main price gains. For big-capitalization stocks, the margins were 13%. Profit margins can be a major clue in finding the best stocks to buy, although the numbers vary widely among industries. For example, retailers tend to have smaller profit margins. Whatever the exact numbers, a company's margins should be among the best in its industry.Let's take profit margins one step further. There are two types of profit margins. One is called the after-tax margin, and it calculates the percentage of earnings that come from sales after taxes have been paid. Let's take one company that earned $10 million from $100 million in sales. This gives it a profit margin of 10%. What if this company had to pay $2 million in taxes? What would that do to the margin? Well, deduct the $2 million tax payment from the $10 million in earnings and you've got $8 million in earnings. Divide that by the $100 million in sales, and the margin is now only 8%. The other type of margin is the pretax profit margin, and -- you guessed it -- it ignores the taxes a company pays. Analysts and investors scrutinize both numbers. Some prefer pretax margins because they show realistic profitability without the distortion of varying tax rates.The rule of thumb for all companies except retailers: seek companies with annual pretax profit margins of at least 18%. After-tax margins should be at all-time highs for the company or within 10% of the high.Of course, increasing profit margins alone don't make for a good investment. You need to keep an eye on all the key fundamentals, such as earnings growth. Rising profit margins mean little if sales are dropping, unless there's a change in strategy and the company drops inefficient product lines, for example. Also, if margins start trending lower, it could indicate the company is losing ground to competition. One other note: increasing profit margins aren't the same thing as increasing earnings, as we've shown with the above examples. Suppose a company earns $10 million from $100 million in sales, resulting in a 10% profit margin. The next quarter it earns $10 million from just $80 million in sales, for a 13% margin. You see how a higher margin doesn't automatically mean bigger profits?Return On Equity: How Efficient A Company Is With Its MoneyROE is one of the most popular ways to evaluate the financial performance of a growth company. ROE, sometimes called earnings power, indicates how well a company is being managed to allow a profit on its shareholder's money. It is also a reliable indicator of what a company can earn in the future. High ROEs, year after year, tend to reflect increasing profitability and superior management. Cyclical stocks, those that roughly move along with the economy, usually show more mediocre ROEs.You should generally avoid companies with less than 17% return on equity. ROEs vary among industries, but this is the minimum you should find acceptable. And be sure to compare a company's ROE against others in the industry to get a realistic comparison. In most industries, the top-performing companies tend to have ROEs of 20% to 30%. Occasionally, companies will boast ROEs of 40% or even higher. The higher the percentage, the more efficient a company is in utilizing its capital. The best stocks of the 1996-97 period had, on average, an ROE of 20%. For big-capitalization stocks, the average ROE was 29%.ROEs have been increasing over the past several decades, largely because high technology has helped cut costs and boost productivity.A Quick Way To Weigh FundamentalsThe Sales+Profit Margins+ROE (SMR) Rating -- part of the IBD SmartSelect® Corporate Ratings (A set of five key stock performance indicators.) -- saves you the arduous task of going over the financial reports of every company and helps you find the best companies in terms of financial performance. The rating looks at a company's sales growth over the last three quarters, its before- and after-tax margins and its return on equity. These four fundamental factors are widely used by analysts. The SMR Rating ranges from A to E, with "A" being the best and representing the top 20% of all companies. The "B" stocks are in the next 20% and so on. The "E" stocks represent the bottom 20% and the lesser-quality companies. The rating also assigns a greater value to stocks in which any or all of these fundamental factors are accelerating. Look for stocks with ratings of "A" or "B." 8 (For Sample Purposes Only) Daily Graphs®, a stock chart service that's a sister company of IBD, contains the SMR Rating (abbreviated "SMR Rate") and specific figures on sales and return on equity. Click for larger image In IBD's stock tables, companies with top fundamentals are highlighted with a black bar. Stocks are selected weekly through a proprietary formula.The Launch Pad9 OK, let's say you've found a company with great sales growth, profit margins and return on equity. What's next? As good as these indicators may be, don't ignore other critical factors, such as a stock's earnings growth (the earnings lesson discusses how to evaluate earnings.), institutional sponsorship (The amount of buying by mutual funds and other institutional investors is important and is discussed in the sponsorship lesson) and relative price strength. (Relative Price Strength Rating takes a stock's price performance over the past 12 months and compares it to all other stocks. The rating is expressed on a scale of 1 to 99, with 99 being best. This is covered in the leaders lesson.) Also, studying a stock chart completes the stock selection picture. (Charts are explained in detail in the charts lesson.) Key Points To Remember• Strong sales growth is one key indicator of a company's success. Quarterly sales growth should be up at least 25% in the most recent quarter. Otherwise, they should be accelerating. • Profit margins tell you how much of a company's sales end up as earnings after expenses. Generally, the higher profit margins, the better. • Return on equity measures how well a growth company can produce earnings with shareholders' capital. Look for ROEs of at least 17%. • You don't have to check the company's financials to be sure a company's sales, margins and ROE are acceptable. Just check the SMR Rating, making sure your stocks are rated "A" or "B." 3. Sponsorship: Catching The Stocks The Pros Are Buying Mutual funds and other professional investors represent the vast majority of trading activity in the market. As such, they wield tremendous influence on stocks, capable of sending their favorite stocks up significantly. Here, you'll learn how to spot the stocks benefiting from "institutional sponsorship." Assess Your Knowledge On This Topic What Is Institutional Sponsorship?There's a term on Wall Street everyone soon learns to appreciate: institutional investors. These are the mutual funds, pension funds, banks and other financial institutions that do the bulk of stock trading on any given day. It is estimated institutions account for about 70% of all trading activity. So when institutions target a stock for purchase, it's more likely to go up in price thanks to the increased demand they create. This professional stock buying is called institutional sponsorship.Institutions make a living buying and selling stocks. They employ analysts, researchers and other specialists to gather comprehensive information about companies. They meet with executives, evaluate industry conditions and study the outlook for every company they plan to invest in. A few institutions are so skilled at using this expertise, they habitually outperform their peers. That's why their stock selections are widely watched.Tracking What The Institutions Are TradingNow, wouldn't it be great if you knew exactly which stocks the institutions are buying and when? Actually, you can.Although mutual funds and other institutions don't disclose their buys and sells frequently, you can track their moves by watching for clues in trading activity.One of the most useful ways to spot current institutional trading is to study volume percent change figures, in other words, how much trading rose — or declined — in a day compared to normal. (By normal, we mean the average daily trading volume over the past 50 trading days.) Because this information is continually updated, it is the quickest way to detect institutional trading in a stock. When volume spikes up 50% or more at the same time the stock goes up in price, that's generally a clear sign that major investors are moving into the stock with both feet. This usually precedes a significant rise in the stock price. But if a stock's price drops on heavy volume, it's a sign large investors may be moving out of a stock. If a stock's trading volume advances but the price goes nowhere, it could mean the stock is reaching a peak. Information about volume changes appears in IBD's daily stock tables. In investors.com, volume figures are continually updated on a 20-minute delay.How To Spot The Big Trading Activity10 . margins mean little if sales are dropping, unless there's a change in strategy and the company drops inefficient product lines, for example. Also,