Finding a home run stock that goes up 100% or more in just a year is difficult enough, but the hardest part is actually waiting around.
This article was originally published by Zacks.com.
A home run stock is one that goes up 100% or more in just a year.
I have hit four such home runs already this year and, with a few more months left, that number could reach five or even six.
The point of this article is not to brag about the past as I didn't always have this kind of success. Instead I want to share with you the lessons learned over the years so you can identify more of these home run stocks yourself.
Finding quality stocks is not easy
Before you can get a stock to return 150% or 200%, you need to find the stock or stocks that have the best potential for returning 100%. It seems like common sense but investors often look for the stocks to triple and quadruple before it has even had a chance to double.
The key characteristics of these stocks are pretty simple to understand, just a little difficult to find. The first step in finding a home run stock is to look for companies that are growing revenues. Without topline growth, a company will have a very difficult time growing earnings. Ultimately, stocks are valued and priced off of earnings and the potential for future earnings growth. So no growth on top means minimal to no growth on bottom, and that won't result in a higher stock price.
Secondly, look for a company that is in a growing industry. It sounds fundamental to say that the growth in stock price will be directly related to the growth of the entire market it services, but that gets lost in the mix. A growing industry will ensure that there is a high potential for growing revenues.
Growth in revenue and an expanding industry are great, but if the company doesn't have some sort of pricing power, that growth will be a false positive. How do you know when a company has pricing power? The answer is simply margin expansion. Look for gross margins to move higher on a consistent basis. That growth will be the key to knowing if management is steadily increasing the price as demand continues.
The biggest driver
Screening tools will help you get a list of stocks that are seeing solid revenue growth and margin expansion. Still, those stocks also need to be carved down to find the ones that also beat earnings expectations.
The single biggest driver for these home run stocks is the move they get after beating earnings. Not just once, but time and time again. This proves that management is doing two things correctly. First, they are managing the growth of the company to continue to produce revenue growth and margin expansion in a prudent way. Secondly, they are able to manage the expectations of Wall Street, which is more easily said than done.
Quarter after quarter after quarter of earnings beats will lead you to home run stocks. Not only will you receive the earnings "pop" on the stock price, you should also witness what we like to call the post earnings drift higher.
After an earnings beat, investment managers may start building positions. They don't want to buy in all at once as they will move the stock too much. Instead, they buy in slowly over a quarter or even two, and that buying power results in the stock price "drifting" higher.
The hardest part
Tom Petty and the Heartbreakers sang it best, "the waiting is the hardest part." A stock might beat an earnings estimate and move higher. It might do it a second or even a third time before it even comes close to being a home run. The key is to have patience and not harvest the gain too soon.
I often see investors happy with a 40%, 50% or even 60% return after just a few months. They get in to a stock just before an earnings report and benefit from a beat. They hold it through the next report and again see the stock increase thanks to another earnings beat. Soon enough, there is a slight pull back and they sell the stock.
This lack of patience is one of the biggest reasons people hit more singles (25% return), doubles (50% return) and triples (75% return) than home runs. An investor needs to have a heavy dose of patience, as that is a key element of what separates them from traders.
Home runs vs. out-of-the-park hits
There is a difference between having a stock return 100% versus a stock that returns 150% or 200%. It only takes a little bit of logic to realize that a stock must first be a 100% returner before it can truly be an out-of-the-park shot. So when you have a homer on your hands, add on an extra dose of patience.
For example, when you purchase a $10 stock that goes to $20, you have a home run. If revenue grows and margins keep expanding, then there is a good chance the company will beat earnings again. That could take that $20 stock to $30 ... but realize that the move from $20 to $30 is only 50% — for those buying in at $20. For you, it means another 100% return on top of the 100% return you already have.
An extra dose of patience can go a long way in investing. One mistake I have made that I don't want to see you repeat is putting a stop on a stock that has a big gain. Yes, stops can help protect your gains, but take caution in setting them up too close to the stock price, especially shortly after a big move is made. Those are the times that stocks can be the most volatile.
Brian Bolan is a Stock Strategist for Zacks.com.
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