SNaC: the Cabot Approach to Picking the Best Growth Stocks

By Paul Goodwin, Chief Analyst, Cabot China & Emerging Markets Report
From Cabot Wealth Advisory 4/9/09 Sign up for free Cabot Wealth Advisory e-newsletter

An Unbalanced SNaC is No Way to Pick the Best Growth Stocks

In trying to explain the Cabot approach to picking the best growth stocks—especially the approach I use in the Cabot China & Emerging Markets Report—I've come up with an acronym.

I call it the SNaC approach.

That means that a great growth stock must have a compelling Story, excellent Numbers and a technically supportive Chart. Story, Numbers and Chart.

I think it really makes sense. And using it can make you a better stock picker for one big reason: it forces you to look beyond a stock's story.

The stock's story is just that. It's all about the company's product or service and why the world needs it, or how people have been wanting it without even knowing it. A story is about benefits, whether it's a lower price for familiar goods, saving lives or making them healthier, or offering opportunities for new experiences in games or style or communication. Stories are appealing, even compelling, but it's not good to stop there.

Numbers are the fundamentals of a company, including profit and loss, assets and liabilities. People who screen stocks for consistent earnings growth or valuation or their ability to beat analysts' expectations are fundamentalists.

Charts are a graphic representation of a stock's reception in the market, and a skilled chart reader—a technical analyst or technician—can get an astonishingly detailed read on a stock's momentum and likely future action from the patterns of price and volume that charts lay out.

But it's story that I'm concentrating on today, because I think humans are trained from birth to appreciate and react to stories. From the moment we graduate from "Goodnight Moon" to the stories that begin "Once upon a time" and end "and they lived happily ever after," we're hooked. We become connoisseurs of the rise of underappreciated heroes and the downfall of overbearing villains.

So, when we discover a company with an appealing story, especially if the company's stock has been ignored or punished by the market, we can sometimes get swept away by sympathetic enthusiasm. Only later will the market teach us that story isn't enough to make a great growth stock.

A few years ago, one of my favorite stock stories concerned a small manufacturer called Capstone Turbine (CPST). The company makes efficient, environmentally friendly MicroTurbines that burn almost any kind of fuel and generate electricity (from 30 to 200 kilowatts) and heat, which can both heat or cool facilities.

Two elements of Capstone's story stand out. First, its product has just one moving part, the turbine rotor itself, that's turned by the combustion of fuel. The vertical turbine rotates at 96,000 revs per minute, turning the generator rotor, which is on one end of the one moving part. The rotor can turn that fast because it rides on patented air bearings that use no grease or oil. Since they have virtually no friction and don't get gunked up with grease, the turbines can be used in remote settings where maintenance is difficult.

The second standout element of Capstone's story is its fuel versatility. The company's Web site says that its MicroTurbines can run on low- or high-pressure natural gas, biogas generated by landfills or sewage treatment plants, flare gas from oil wells, diesel fuel, propane or kerosene. Basically, whatever hydrocarbon you have, the turbine can burn it.

I'm not writing about Capstone Turbine in order to recommend the stock. But doesn't it sound great?! It's exactly the kind of story that you could tell a friend about at a cocktail party or over lunch. It's easy to be enthusiastic because the story is simple and compelling; it looks like a can't-miss proposition.

Unfortunately, the numbers and the chart aren't quite so attractive. Capstone has a record of yearly losses that goes back as far as 2000, and maybe farther. And the company isn't projecting a profit at least through 2010. Without profits, there are no valuation metrics to work with.

The chart is similarly ambiguous. CPST has made some monster moves in the past, including a big run when the company participated in a pilot program with Wal-Mart to determine whether Capstone MicroTurbines might be useful in heating and cooling the company's stores that litter the American landscape. If that had worked out ...

But no. It's a long way down from 98, which is where the stock was trading back in 2000. Even as recently as June 2008, the stock was at 4.4, far from it's penny stock lows.  Unfortunately, it took a big move on April 2  to boost the stock nearly 10% ... all the way to 78 cents.

This is obviously a cautionary tale. The moral is that really appealing stock stories have the power to knock your judgment off balance. All great stocks have great stories; but not all great stories are great stocks.

In stocks, as in life, you need a fully balanced SNaC to give you real nutrition.

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