As a portfolio manager specializing in common stocks, I have spent more than 40 years researching and trying to identify the common characteristics of top-performing stocks. I've put my key findings on achieving superior returns in the context of what not to do in selecting stocks. My research supports these ideas, and some may come into conflict with conventional thinking.
1. Short selling: The Dow has risen from just over 1,000 at the end of 1982 to just under 30,000 as of this writing. My research has found that on average, the stock market rises six of every 10 days. Investors can find better odds in Las Vegas than trying to short the market or shorting specific stocks even though this idea offers great intellectual appeal.
2. Using price-to-earnings ratio (P/E) to evaluate stocks: In 2019, Merrill Lynch reported that 80% of investors use P/Es as their primary investment tool. S&P Dow Jones Indices reported that 87% of all types of equities funds failed to beat the S&P Composite 1500 Index over the past 15 years.
The general perception on P/Es is that lower P/E stocks offer greater value. This viewpoint runs counter to the evidence at hand. William O’Neil of IBD studied P/Es and found that stocks selling at an average P/E of 35 returned on average 120% during 1996-1997. I studied the top 10 stocks during the period of 2006-2015, which achieved cumulative price gains of 845%-5,345%. I found that these stocks started their runs at an average P/E of 40X. This research demonstrates that profits growth trumps P/Es in evaluating stocks.
3. Focusing on positive earnings surprises: Wall Street is fixated on earnings surprises, both positive and negative. Quarterly earnings reports are almost always discussed in the context of a positive or negative surprise, with no mention of earnings growth. Consider two stocks, one reporting a lesser loss of 4 cents per share versus the estimate of a 5 cent loss, for a 20% surprise. Another company reports $2 per share versus $1 per year ago, but falls short of the estimate by 20%. My research shows that earnings growth is far more important than a quarterly surprise in stock evaluation and that conventional reporting on surprises has no relevance to a company’s growth trajectory.
4. Ignoring money-losing companies: Most investors shy away from money-losing companies. Moreover, Wall Street often comes to a wrong conclusion in rating a stock because of its reliance on earnings per share (EPS), which can give a distorted view of profitability. In looking at the biggest winning stocks during the period of 2010-2019, four of the top 10 performers did not make money during that period.
Wall Street rates stocks based on EPS, which is one of several ways to evaluate profits growth. The EPS methodology makes no adjustments for capital expenditures such as research and development in the income statement. Enterprising investors who are willing to roll up their sleeves and take a hard look at deficit companies can sometimes be rewarded by finding a diamond in the rough.
5. Being less than 100% invested: Barron’s reported in late June that investors were sitting on a record amount of cash after fleeing the stock market in March around the time of the bottom of the bear market. Consider that we have just come through one of the strongest rebounds ever from a bear market low and one in which the S&P 500 vaulted roughly 38% from its bottom to the end of June with a record amount of cash on the sidelines. This is yet one more example why investors should remain fully invested at all times.
This article originally appeared on Forbes.
