William J. O'Neil: A Deeper Dive Into the Fundamentals

In chapter three of his 2009 book, “How to Make Money in Stocks: A Winning System in Good Times and Bad,” William J. O’Neil gave his take on quarterly earnings — and big increases in them — as a predictor of stocks that “might” produce much higher-than-average returns.

I highlighted the word “might” because quarterly earning increases alone are not enough to trigger a buy signal. “Any company can report a good earnings quarter every once in a while," O'Neil wrote. "And as we’ve seen, strong current quarterly earnings are critical to picking most of the market’s biggest winners. But they’re not enough.”

In chapter four, O’Neil took a dive into annual earnings growth, to confirm the promise implied by strong quarterly earnings; he also wanted investors to be aware of what the price-earnings ratio means —Â and doesn't mean. To ensure investors find stocks with enough of the right stuff, he discussed 12 criteria:

1. Stocks should have an average earnings growth rate of at least 25%, and preferably higher. O’Neil’s research showed that the median annual growth rate of all outstanding stocks, between 1980 and 2000, was 36%. It is also helpful to look at the consensus among analysts, recognizing that they are making forecasts that are subjective.
2. Return on equity (ROE) should also be climbing. It is a measure that shows how efficiently management is using the capital with which it is entrusted. The greatest stocks over the previous 50 years (before 2009) had shown an ROE of at least 17%. Second, is the cash flow per share increasing? O’Neil noted that some strong companies can generate annual cash flow per share that is at least 20% higher than actual earnings per share, and this too can confirm the company is worth considering.
3. How stable is the three-year earnings record? There should be strong, consistent growth in each of the past three years, with no dip in the second year, even if earnings catch up again in the third year.
4. Assess the normal stock market cycle. In normal times, bull markets last from two to four years and then give way to corrections or recessions. Growth stocks often lead as the market returns to bullish territory; their earnings have been increasing quarter by quarter, but stock prices have been depressed because of general market conditions. As a result, the price-earnings ratios may be compressed to the point where they become attractive to institutional investors.
5. Eliminate losers in a group. The three-year guideline, as in No. 3 above, should weed out 80% of unattractive stocks. For a couple of examples of stocks that did get over the three-year hurdle, he considered these stocks: Xerox (XRX, Financial) had been growing at an average annual rate of 32% before its share prices took off in March 1963. Priceline (now a subsidiary of Booking Holdings (BKNG, Financial)) doubled its earnings between 2004 and 2006, before its share price tripled in the next year and a quarter.
6. Both annual and current quarterly earnings must be excellent. “A standout stock needs both a sound growth record in recent years and a strong current earnings record in the last several quarters," O'Neil wrote. "It’s the powerful combination of these two critical factors, rather than one or the other, that creates a super stock, or at least one that has a higher chance for true success.”
7. Don’t give much weight to the price-earnings ratio. “Our ongoing analysis of the most successful stocks from 1880 to the present shows that, contrary to most investors’ beliefs, P/E ratios were not a relevant factor in price movement and have very little to do with whether a stock should be bought or sold.” Instead, investors should give the most weight to the state of earnings change: Is this company “substantially” increasing its earnings growth rate?
8. When the earnings growth rate is strong, investors should be willing to buy at price-earnings ratios of 25 to 50. As O’Neil summed up: If the market is strong, don’t be put off a stock because its price-earnings ratio is too high, and never buy a stock simply because the price-earnings ratio makes it appear a bargain. Such an approach, he warned, would have led investors to miss the great capital gains on stocks such as Microsoft (MSFT, Financial), Cisco (CSCO, Financial) and Home Depot (HD, Financial).
9. More on price-earnings ratios: O’Neil observed that many Wall Street analysts recommend a stock simply because it is selling at the low end of its historical range. That happened with Gillette (G, Financial) and Coca-Cola (KO, Financial) in 1998. Their ratios looked attractive, but earnings at both companies were slowing down. Investors who bought solely on the price-earnings would not have bought a bargain. In general, rationales based on the price-earnings ratio often ignore basic trends.
10. Be careful about using price-earnings to assess companies across an industry. Do not conclude that the stock selling at the lowest price-earnings must be undervalued. “The reality is, the lowest P/E usually belongs to the company with the most ghastly earnings record,” O’Neil also wrote. “The simple truth is that at any given time, stocks usually sell near their current value.”
11. In the right circumstances, such as “small but captivating companies [with] revolutionary new products,” a high price-earnings ratio may not be too high. For example, in September 2004, Google/Alphabet (GOOG, Financial)(GOOGL, Financial) had a price-earnings ratio in the 60s, while its shares were selling for $115. By January 2006, prices hit $475 per share.
12. Don’t sell your shares just because the price-earnings ratio seems too high. O’Neil told the story of a client at another brokerage who stormed into the office and shouted that Xerox was vastly overpriced at 50 times earnings. He then sold 2,000 shares short at $88 per share. Shortly after this happened in June 1962, the stock market began climbing up from the bottom of the cycle. Xerox took off even faster and hit $1,300 (before splits) and a price-earnings ratio of more than 80. The author does not tell us what happened to the man who sold short, but we can be quite sure he would have learned a lesson.

(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.