Beyond the Buzz: The Art of Finding Growth Stocks with Strong Fundamentals

Discover the Key Factors to Look for in a Growth Stock

Hi Everyone,

The biggest risk to successful growth stock investing is human emotions, such as fear and greed, which all too often lead us to do the wrong thing at exactly the wrong time.

Wall Street is more addicted to fashion than Hollywood or the garment industry. And the latest fashion trend often comes packed with a nice story about why a stock/sector will bring us riches - until the fashion trend fades and a new one appears.

What we need instead is an emotionless, rule-based system that we can apply over and over again with a high accuracy rate.

I am going to show you 8 key variables that you should look out for if you want to find stocks that actually have strong fundamentals and aren’t just smoke and mirrors.

Let’s get into it.

1. Earnings Revisions

We look for stocks whose earnings estimates are revised upward by the majority of Wall Street analysts who cover and research these companies. To understand this better, let’s take a step back and see through the eyes of an analyst. Usually, those jobs are paid well and the people want to keep their position. What is more likely to give them a positive standing in the office? Estimating on the higher end or on the lower end?

If analysts guess too high and the company reports lower earnings than expected, there’s a good chance that the price of the company’s shares will fall. If, on the other hand, analysts guess too low and the company earns more than expected, it’s taken as good news and very often the stock spikes higher.

If you are going to be wrong anyway, be too low rather than too high. Nobody is going to lose their job if the guess is on the low side and the stock goes up in price on the “error.” For this very self-serving reason, analysts do not like to raise their estimates of earnings unless there is strong evidence that the business is doing much better than expected.

This brings us to the next point.

2. Earnings Surprises

This shows how much the actual reported earnings are above or below the average guess of Wall Street analysts. Here, we want to find stocks that do better than Wall Street thinks they can.

Earnings surprises are easy to spot because they usually make up the headlines during earnings season: “Stock XYZ Beats Analyst Estimates.”

It might sound silly when we take into account that analysts tend to estimate earnings on the lower end, therefore making earnings surprises more likely. But that’s how it works. I prefer to check if the earnings are in line with what the management expected because this gives me a clearer picture of their capability to plan and communicate with shareholders. But I’m not the one who makes the rules.

3. Sales Growth

One of the most important factors for a growth stock is that it’s actually growing. First of all, this is an important measure because Wall Street attaches great importance to it, and second, it’s because sales numbers are clear and difficult to manipulate. Sales numbers are less prone to accounting tricks.

Companies whose sales are growing at a very fast rate are among the best bets to become big winners in the long run. If a company's sales keep going up over a long period of time, it seems like they must have a product or service that people want.

Companies with sustained sales growth will generate returns that are independent of the market or economy as a whole. This is also useful for investors who wish to learn how to disregard market chatter. Consistent sales growth is an indicator that a business functions in its own universe and is less reliant on economic cycles.

4. Operating Margin Growth

The operating margin of a business is the profit remaining after deducting direct expenses such as salaries and overhead. We examine if this percentage margin is shrinking or expanding annually. When a company's product is in such great demand that it can continue to raise prices without incurring additional expenses, the company's operating margin will expand.

Suppose a company's operating margin is increasing annually and quarterly. In this situation, it shows that the corporation is earning more profit per dollar of revenue collected from the sale of goods or services. Frequently, we see businesses with spectacular sales growth but low operating margins. Thus, a company may have decreased pricing to boost sales, which is fantastic for the top line but not indicative of consistent growth. Other companies, particularly those in the service industries, may see sales growth, but profits may be eroded by the addition of new staff and marketing expenses.

There are a number of reasons why margins may experience a large but short jump. First, a business may establish cost controls and cut expenses, so that each dollar of sales contributes somewhat more to the bottom line. This is great, and I am always pleased when the companies in which I invest are fiscally responsible, but it is not a sustainable source of growth.

The other way in which profit margins expand is when a company sells more of its product but the basic costs of the business do not go up. This is the interesting part. You probably encountered this numerous times without paying attention to it:

We see the same product that has the same production costs sold at a higher price simply because the packaging is different. That’s a smart way to charge more for what is basically the same product. Less obvious examples include restaurant chains like Starbucks SBUX 0.00%↑, McDonald's MCD 0.00%↑ , and Yum Brands YUM 0.00%↑ . You often see those companies offering a tiny bit smaller portions while the price stays the same.

Always keep an eye on margins. Increasing margins typically indicate that a company is dominant in its industry or has a new product. Sooner or later this will create competition, and profit margins may begin to erode. Here is where a moat is beneficial.

5. Free Cash Flow

Free cash flow is the amount of money remaining after a business has paid for its operating expenses and the maintenance and repairs required to stay in business. Companies can use their free cash flow to buy back stocks or pay out dividends. Both of these measures have led historically to higher returns, as I wrote in previous articles:

Buybacks and Abnormal Returns

The easiest strategy for market beating returns

If there’s plenty of cash left over, it can be spent growing the business. Free cash flow gives a company a lot of flexibility in its decision-making. And I better invest in a company that “doesn’t know what to do with all the cash” than in one that is struggling to keep the operation going.

6. Earnings Growth

Although I put more attention to Free Cash Flow than earnings, I still need to play by Wall Street’s rules. And earnings-per-share are an important factor for most investors. When a stock has higher earnings than the last year, it’s usually taken positively.

A company with increased year-over-year earnings is automatically worth a bit more each time it reports, and the stock price will often increase to reflect this.

This brings up to the next factor:

7. Earnings Momentum

This metric represents the percentage increase in earnings from one year to the next. Companies whose earnings are accelerating and expanding quicker from year to year are more appealing than those whose earnings are decelerating.

Not only do we want to see earnings be higher year over year; we like to see them up even more each quarter.

8. Return on Equity

Return on equity (ROE) measures the profitability of a company. The greater this figure, the more successful a company is and the greater the return on investment that management provides shareholders. Companies that are dominating in their field typically generate extremely high returns on equity. ROE can reveal how efficiently a company uses the cash it creates from operations.

If a company gives its shareholders a high return on their money, it is much less likely to do things that will hurt the value of its shares, like announce a new stock offering or borrow money to keep the business going. A company with a high return on the money it has invested is more likely to have strong free cash flow.

Final Thoughts

You won’t find constantly stocks that score on all of those eight variables - but you don’t need to. They should serve as an orientation to keep you out of trouble. See investing as a Checklist. Learn what drives returns and what has worked in the past and you should do well in the long run. Perfect stocks are rare, but above-average ones also do the job.

This also helps us avoid stocks that are likely to be bad investments. By focusing on the numbers, we try to take the guesswork out of picking winning stocks. Traditional Wall Street analysis and investing involves talking to the company's management, customers, and suppliers, and then building complicated hypothetical models to try to predict how the company's finances will do in the future. This oftentimes leads to the typical storytelling that you see in mainstream financial media.

I think a better way is to look at results that will sooner or later show up and be a reflection of management decisions. Companies can grow over years or even decades, so there’s no need to jump in before it even starts.

The proof is in the numbers and a careful study and analysis of the numbers can help us find stocks with growth potential and big gains in the future while avoiding stories and nonsense. When investors get caught up in the story, they may believe the hype about a stock or market and stay in it for a long time after they should have left.

Don’t be a bagholder.

I hope you learned something today, until the next issue. 👋

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Disclaimer: This analysis is not advice to buy or sell this or any stock; it is just pointing out an objective observation of unique patterns that developed from my research. Nothing herein should be construed as an offer to buy or sell securities or to give individual investment advice.