While many in the investing community are willing to leave quarterly earnings to speculators and short-term investors, William O’Neil saw the quarterlies as the key indicators of potential long-term gains. In chapter three of “How to Make Money in Stocks: A Winning System in Good Times and Bad,” he presented multiple examples of companies that went on to deliver great capital gains after posting accelerated earnings growth for two consecutive quarters:
- Dell DELL: Share prices took off in November 1996 after quarterly earnings increases of 74% and 108%. Ultimately, its shares went up 1,780% before topping out.
- Cisco CSCO: Shares rocketed up 1,467% in the first three years of the 1990s, after posting quarterly gains of 150% and 155% in 1990.
- Alphabet GOOGGOOGL: In the two quarters before it went public, Google's parent company posted earnings gains of 112% and 123%. And, as the saying goes, “The rest is history.”
O’Neil went on to argue this wasn’t just something that happened in the 1990s or recently. For example, Studebaker’s quarterly earnings went up 296% before the share price more than quadrupled in 1914. Cuban American Sugar produced a quarterly increase of 1,175% in 1916 and the share price jumped from $35 to $230.
The author added:
“In fact, if you look down a list of the market’s biggest winners year-in and year-out, you’ll instantly see the relationship between booming profits and booming stocks.
And you’ll see why our studies have concluded that: The stocks you select should show a major percentage increase in current quarterly earnings per share (the most recently reported quarter) when compared to the prior year’s same quarter.”Â
Research by O’Neil showed that of the 600 best-performing stocks between 1952 and 2001, three-quarters of them displayed earnings increases averaging more than 70%, just before the share price increases that made them spectacular stocks. The author also noted that while only 1% or 2% of stocks may have such increases, they do exist.
Still, according to O’Neil, investors should go forward cautiously to avoid value traps and other pitfalls. How?
- Be sure the earnings per share number is calculated by dividing total after-tax profits by the number of common shares outstanding. He wrote, “This percentage change in EPS is the single most important element in stock selection today. The greater the percentage increase, the better.” As we saw, though, many speculators in the 1990s forgot there had to be real earnings, not just promises.
- Don’t buy just because quarterly earnings are taking off; O’Neil cautioned investors that quarterly earnings are just one of seven components in the CAN SLIM system. However, quarterly earnings are the most important factor.
With that, O’Neil launched into a discussion on finding true quarterly champions, which are companies that have done a good job on the fundamentals—as well as delivering flowery prose in their reporting. His criteria include:
- How much, as a percentage, are the current quarter’s earnings per share above the same quarter in the previous year? The “per share” is a key metric; there is no advantage in higher earnings if the company has simultaneously increased (diluted) the share count. In other words, net income may have gone up 10%, but if shareholders are only seeing a 5% increase, then this company should not be on investors’ short lists. Also, be sure to compare a quarter with the same quarter a year earlier, and not with the previous quarter in the same year. This is especially important when assessing companies affected by seasonality.
- Take out any one-time, extraordinary gains. Activities such as the sale of real estate properties can distort quarterly earnings and comparisons with the same quarter in previous years.
- Establish a hurdle rate for increases in current earnings. Earlier, O’Neil told readers that three-quarters of the best prospects had quarterly increases of at least 70% for at least two quarters. Now, to take in all prospects, he suggested 20% while saying some successful investors use 25% or 30% as their hurdle rate. In bull markets, he liked to see gains of at least 40%. As he wrote, “You have thousands of stocks to choose from. Why not buy the very best merchandise available?” Serious investors also will check consensus earnings estimates for the next couple of years.
- Stay away from aging companies with mediocre management, what O’Neil called “entrenched maintainers” or “caretake management.” They are also described as companies that must work hard just to get their returns up to 8% or 10%.
- Seek out companies that display accelerating quarterly results. Research showed that in almost every case, there had been accelerated earnings growth somewhere in the previous 10 quarters. For example, a company that had been returning 15% a year suddenly starts turning out 40% or 50% improvements over the same quarter in the previous year.
- Sales growth must accompany earnings growth. Consider the case of Waste Management WM in early 1998: Earnings had increased for three consecutive quarters by 24%, 75% and 268%. However, sales had only gone up 5%. Within a few months, the stock price collapsed from $50 to $15 per share.
- Avoid stocks that show two quarters of significant earnings deceleration “Even the best organizations can have a slow quarter every once in a while. So before turning negative on a company’s earnings, I prefer to see two consecutive quarters of material slowdown,” O'Neil wrote.
- Check log-scale, weekly graphs. How do you know if a stock is truly accelerating or decelerating? Logarithmic-scale graphs show these changes in the percent rate of quarterly earnings interest. This is because an inch or other measure means the same percentage of change anywhere on the graph, while the arithmetically-scaled cannot. (GuruFocus charts can be converted to log-scale by selecting the Chart Options button and selecting "Log" from the drop-down menu.)
- Check peer stocks, “If you can’t find at least one other impressive stock displaying strong earnings in the group, chances are you may have selected the wrong investment.
In conclusion, strong earnings growth for at least two consecutive quarters can signal a stock’s price may be ready to take off. But be sure to carefully assess the nature and strength of these earnings.
(This article is one in a series of chapter-by-chapter digests. To read more, and digests of other important investing books, go to this page.)
Disclosure: I do not own shares in any company listed, and do not expect to buy any in the next 72 hours.
Read more here:
