Fundamental Analysis - Lesson 6

Once you understand the technical side of the equation, your next step is to examine a company’s fundamentals to see if it qualifies as a super-growth stock. Unlike technical analysis, the fundamental analysis of a company’s financial ratios involves making some judgments about future growth potential. So it takes a little practice. After reading this lesson and putting its principles to work in real life, you’ll get the hang of it.

A Stock, Like Love, Thrives on Romance and Dies on Statistics

In lesson two of this investment course, we explained the importance of romance in the stock market. Specifically, we told you that a great growth company can see its stock soar to unheard of heights—all on the back of what appears to be questionable fundamentals. This happens because savvy investors are able to understand the long-term potential of a firm, and thus purchase and hold onto its stock. They’re buying the future, the potential. It isn’t until much later that the sexy growth forecasts are replaced by cold, hard facts. More often than not, this is when a stock will reach its point of maximum perception and begin to head lower for many months or even years.

We’ve learned from experience that the biggest and fastest profits for investors often come when the stock is in the romance phase. Thus, it’s critically important that most of your potential purchases have the fundamental characteristics that support a huge burst of romance in the stock.

A Big Idea Creates Fuel for Romance

Knowing that romance plays such an important role in a young growth stock’s life, you shouldn’t be searching for a particular statistic (growth rate, size of its addressable market, profit margins, etc.), although examining those figures is helpful. Start by looking for a company that has a big idea—one that leaves few, if any, limits on its future growth potential. It’s these big ideas that create an atmosphere that can push a growth stock to dizzying heights!

But how do you determine if a company has a big idea? Well, there’s no science here, but here are a few characteristics you should look for:

Huge mass market. Your target company should have a virtually unlimited market to sell into. This should be measured in terms of dollars (at least a $50 billion market) and customers (hundreds of thousands or more). The dollar potential is more important, but we prefer to see both.

Barriers to entry. Once you know that a company is targeting a gigantic market, you want it to have that market all to itself! Of course, there are no monopolies out there anymore, but ideally, it will be difficult for a new competitor to make inroads. Barriers to entry can come from a strong patent position, high switching costs (i.e., it’s expensive or time-consuming for a customer to switch to a competitor), a high level of required expertise, or simple market dominance.

Recurring income. Most of the big winners over the past half-century have been firms that have a recurring revenue stream. The classic example is the razor-and-blade model, where Gillette sells you a few razors and you keep buying the blades for life. Many service firms exhibit recurring income, as customers become dependent on their services (web hosting, for example). 

Margin potential. Just how profitable can this business become? Is it heavily dependent on manufacturing, which usually lends itself to lower margins? Or does its business model add incremental customers and revenue at a low cost? You don’t need to rule out every firm that has lower than average margins, but remember that your biggest winners are likely to be those that can be extremely profitable and become virtual money-making machines.

Statistics. The potential for romance is the most important thing to consider, but fundamental analysis isn’t complete until you study the company’s growth. Here are a few numbers you’ll want to check before you put a stock on your buy list:

Revenue growth. Considering the number of companies operating at a loss these days, revenue growth has become almost as important as earnings growth. Ideally, you want to see revenue growth over 100% year over year. Acceleration of that growth over the most recent few quarters is also a great sign. For real hypergrowth firms (growing revenues, say, over 300% per year), you’ll want to track the quarter-over-quarter revenue growth figures as well.

Earnings growth. For those true growth companies that have earnings, you should look for the same trends as with revenue growth—triple-digit growth and an acceleration of growth.

Profit margins. We’ve already talked about the importance of upside potential for a company’s margins. But you also want to see what those margins actually are! If a company is profitable, its margins should be growing on an annual, or, better yet, quarterly basis.

We track two other metrics, but they don’t fall within the definition of fundamental or technical analysis. But they are still helpful to include in your overall analysis.

Management ownership. It’s good to see a healthy percent (15% or more) of the total outstanding shares owned by insiders. Beware newly public companies, though, because insiders are often restricted from selling any of their shares for about the first six months (the “lock-up” period). A company that went public less than six months ago, for example, may have a large percentage of insider ownership, but that may represent possible future selling pressures on the stock when the lock-up is over.

Mutual fund ownership. How many mutual funds own the firm’s stock? Has the number been growing in recent quarters? You want to see at least a couple dozen mutual funds on board to ensure the stock has some institutional support. And you like to see that the number of funds has been steadily increasing, as these large purchases will drive up the price. But beware: if too many funds own the stock, it may be a signal that it has already had its major advance.

Putting it All Together

Now we have discussed the important fundamental and technical characteristics that are found in most great growth stocks. The key is to use fundamental and technical analysis together. A great chart is nice to look at, but the company may not be worth investing in unless it also has a terrific long-term growth story. Likewise, a company may have a terrific fundamental story, but its chart (which is really what you’re buying) may not look so good.

Only if both the fundamental and technical analysis look outstanding should you consider a stock for purchase. By sticking to this system, you’ll automatically focus on only the very best growth stories with stocks under intense accumulation. By buying into these situations, you’re one-third of the way to a great investment.

The other two-thirds of the equation (holding and selling the stocks you’ve bought) will be discussed in the coming lessons.

J. Royden Ward employs extensive fundamental analysis to determine which stocks are undervalued for Cabot Benjamin Graham Value Investor

Next: Holding Great Growth Stocks

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