Growth Stock Ingredients
It was Winter 2016 and I remember asking an old pit trader from the 70s about his thoughts on Position Trading vs. Swing Trading. He told me both work but people nowadays think swing trading is a maximum hold period of 1-6 weeks. He said back in his day (the old cliche), swing trading meant 6-12 months! Remarkable how times have changed.
Needless to say, there are many ways to extract money out of this market. Whether you are a Forex, futures or options trader, ETF investor, or growth stock enthusiast, it doesn’t really matter. There are so many ways to build wealth on various timeframes. But for the purpose of this blog, I will be generally targeting the growth stock investor/trader audience. The reason being, that is my specialty and quite honestly I know zero about anything else. I will reference the late and great Bruce Lee:
“I fear not the man who has practice 10,000 kicks once, but the man who has practiced one kick, 10,000 times.”
So my background is as follows: I have been an amateur growth stock investor (mainly position/swing trading) since 2004 and follow William J. O’Neil’s (WON) CANSLIM methodology. In college, my major was Finance and this is where my passion for the stock market began.
I can recall a class project in my Securities Analysis class in September 2004 where we were challenged to select the “safest” and “cheapest” highest returning stock. My pick was Temple-Inland, a corrugated packaging and building products company located in Austin, Texas of all places. I loved this company because of its “cheap P/E” and PEG ratios as well as the “undervalued” balance sheet. I believe I came in last place for this project and to my surprise the person who came in first place bought Taser. Taser had just climax topped and he bought a trade-able bounce into support which he sold for almost a double.
The professor gave him a “C” because even though he won the contest, the stock didn’t meet all of the value-investing type criteria. I immediately asked my peer how he knew to buy that stock and where to buy it. He told me about this book called How to Make Money in Stocks (HTMMIS) by William J. O’Neil. I hopped in my car, went straight to Barnes and Noble, and purchased the book. From that moment, my life was changed and I was hooked.
Now, everyone who knows me in the FinTwit universe knows that I post my trades in real-time as well as my portfolio. I do this to show the good and sometimes the challenging and inevitable times of trading. But now that we have that out of the way, there is a logic to my madness. You will notice that most of my stocks have a certain fundamental characteristic…Do I always abide by this particular metric? No, because as I mentioned earlier, I also swing trade. But the majority of my portfolio will house stocks that display this core tenet of the CANSLIM style.
So without further a due, I present, annual earnings per share (EPS) estimates for the current and forward-looking year. This key fundamental characteristic has led me to so many big winners. WON’s book, HTMMIS, mentions that the ideal number for the current year’s and the following year’s forecast is at minimum 25%. This is such an underestimated tool in position or even swing trader’s belts.
During a bear market, job number one is to protect capital. But, your job is to also wait and begin building a watch list of stocks showing relative strength. Having said this, don’t stop there! You want to find companies that have big estimates in spite of the market backdrop showing relative strength.
Let’s take this most recent bear market of 2020. You had stocks like DocuSign, Tesla, Dexcom, and Zoom to name a few that have had some amazing runs since March. What I have noticed over the years is that there will be big runs in stocks like Snapchat or Sea Limited that have no annual profitability. Another that comes to mind is Overstock.com now and in 2017. Sometimes, a story and LIQUIDITY is all an institution needs to establish big positions.
Having said this, it’s undeniable that the majority of big institutional quality winners have come from stocks with great quarterly and annual EPS growth. So why is this? What did WON see that no one else saw in the 1960s? He saw a RUNWAY. An earnings runway.
He knew that many mutual fund managers needed long-term EPS growth prospects to be able to invest money for the fund. As we all know, the larger institutions like Contrafund, control equity prices. Because they have so much to invest (millions or even billions), they leave little footprints and clues on the chart.
These big boys don’t just have CANSLIM at their disposal. They have complex quantitative modeling, forecasting tools, and proprietary information we as retail traders do not have permission to view. Am I saying that all institutions have a mandate to buy only companies with consistent profitability? No, absolutely not.
But, many of the bigger funds have that mandate. Just look at the holdings of these funds and you will see. Where are they concentrating their money within the growth spectrum? Facebook, Amazon, Netflix, Microsoft are names that come to mind. There’s no secret here that these are on the top of their shopping list. But as we know, when a stock becomes over-known and over-owned, it becomes very difficult for it to double quickly.
So, what I am looking for is a company with generally greater than $50,000,000 in daily average liquidity, more than 25% in annual EPS estimates for the current and forward year, and a fresh, new kid on the block, or turnaround story. Also, I would prefer a company that has been incorporated for less than 10 years.
There are obviously other fundamental metrics in CANSLIM, but for purposes of brevity, we will stay on topic. So, if attempting a big hold, say for 2-5 years, you need that earnings runway. In the front of the orange/green copies of HTMMIS, you will see charts of historical True Market Leaders. In some of the charts, you will notice a line connected by dots that tends to follow the weekly price action. This line is called the trailing twelve month EPS line or TTM. This line is calculated by taking the prior four quarters of EPS results and dividing it by four.
As each quarterly report is released, the further back quarter drops off and another data point is revealed. If you overlay this line with a weekly logarithmic chart, you will see a pattern. Again this blog isn’t about quarterly EPS and certainly, the movement in stock price doesn’t move solely based on quarterly results.
Why? It’s because the market is a discounting mechanism. What this means is that the market is looking out 6-18 months when marking the fair market value of the stock. As a result, it is my opinion that the institutions need to see strong estimates as well as healthy quarterly reports to either buy or hold their investments.
Let’s discuss the relevance of EPS estimates as it pertains to which year to look out to. Now at the time of writing this, it is September of 2020, the current year estimates are becoming less important because as the year goes on and the latter you get into the year, the higher the likelihood that the market has already priced in those 2020 estimates. What this means is, it is more relevant to look to 2021 or even 2022 forward year estimates.
You have to be mindful, however, of January or another odd month fiscal year ends. January 2021 estimates could even be less relevant than now because we are in September (at the time of writing this). Thus, it’s more practical to look at January 2022 estimates.
Generally speaking, the markets hate uncertainty and when the runway becomes clouded or is re-adjusted downward across the board, that could mean you have an impending correction or bear market coming. Various events can trigger a board-based selloff like Coronavirus, China Trade War, housing market crash, 9-11, internet bubble of 2000, etc.
The list goes on and on and the pundits will argue on media as to why what the cause is and it really doesn’t matter in the eyes of a trader/investor. We are more concerned with what (PRICE) as opposed to why.
So to wrap this up, I will leave you with this. Focus on young companies with a dynamic story that are showing not only amazing quarterly EPS growth but that are also showing a strong 1-2 year outlook. Sometimes this will require you to research the story in detail so you have the conviction to sit through natural and normal corrective periods. If you are a swing trader, this might matter less to you but that certainly doesn’t mean you can’t use this to your advantage to catch the intermediate moves between bases.
Either way, I hope everyone enjoyed this blog and I encourage you to go back and look at the key characteristics both technical and fundamental of historical True Market Leaders. You might surprise yourself with something you find that you will use to your advantage on the next big winner!
Take care, be safe, and good luck.