Earnings Power Stocks for 2009

After my book It’s Earnings That Count (McGraw-Hill, 2004) was published, The Motley Fool’s Tim Beyers asked me what criteria he should use to build a mechanical screening to find his own earnings power-type stocks. An earnings power stock is a company that has 1) high-quality earnings, 2) a durable competitive advantage, and 3) an attractive valuation, as I have written about since 2002 for RealMoney.com.

Every December since, Beyers has run a screen for the upcoming year. We now have four years of results, and the performance is impressive. Our Earnings Power screen has:

1. Beaten the S&P 500 four out of four years.
2. Not had a down year.
3. Grown at a 21% compound annual rate, vs. -6% for the S&P 500 (dividends excluded for both Earnings Power screen and the S&P 500).
4. Turned a hypothetical $100,000 investment in Earnings Power picks into $216,000, vs. $78,000 for the S&P 500.

Past performance is not always a reliable guide to future results. On the other hand, so far, so good.

So what criteria does the Earnings Power screen use? And what companies get the green light for 2009?

I’ll answer these questions in a moment. But first, let’s look at 2008. Given the carnage in stocks, you probably want to know how the Earnings Power screen avoided losing money.

Well, the Earnings Power screen didn’t own any stocks last year. That’s right. When Beyers fired up his Capital IQ database in December 2007, no company qualified. Out of the thousands of stocks to choose from, not a single company passed our 7-point test. The Earnings Power portfolio sat on the sidelines last year while us humans got pummeled to varying degrees.

What are these criteria? Here are the factors I gave Beyers for his first column, which we haven’t changed. The quotations are my commentary from that first column.

1. Average five-year revenue growth of 8% or better. “This is your indicator that the company is making a product or service that customers can use. But it's important to watch out if the number is too high. For example, 40% is likely unsustainable. On the other hand, if you've found a company growing at only 2% to 3%, it probably operates in a mature market. Low sales growth is almost always a red flag."
2. Annual earnings per share growth of 7% or better over at least the past 12 months. "As with sales, you don't want 20% to 25% because that's probably not sustainable long-term, and any company that is growing that fast may be peaking. A company growing at 7%, however, may just be starting to accelerate, leaving plenty of opportunity for investors.
3. Average five-year return on equity (ROE) of 10% or better. "This is simply the best way to gauge management's use of shareholders' money to fund growth. A higher number here is usually better, though it's important to remember that a highly leveraged firm can still have a high ROE." In hindsight, I should have used return on capital instead, which is a measure of capital productivity for all the wealth that a company employs. But we are sticking with what’s working.
4. Debt equaling no more than half of equity. “This helps eliminate the firms that have high ROE but are also so highly leveraged that they would be in trouble if creditors came calling at the wrong time.”
5. Institutional ownership of 60% or less. “John Neff gave a great quote in which he relayed some advice from his father. His father said merchandise well bought is merchandise well sold. That's a motto for the value investor, but it can also be a motto for the conservative growth investor. Low institutional ownership leaves room for mutual funds and others to come in and discover the firm and push the share price higher. On the other hand, if 98% of the stock is already owned by institutions, then the most likely decision they'll make next is to sell, and that will create downward pressure on the shares."
6. A short interest ratio of 5% or less. "Considering the way shorts make money, they have to be more dogged and more research-intensive. It's hard to imagine that you or I would know more about any individual stock than the most tenacious participants in the stock market. High short interest is always a warning sign."
7. A price-to-earnings ratio lower than the industry average. "There's no substitute for getting in on a stock cheaply. A lower-than-average P/E increases your chances of finding a stock selling at a discount."

Now, let’s introduce our picks for 2009. As of a few days ago they are Exxon Mobil (XOM), Tenaris (TS), Continental Resources (CLR), KHD Humboldt Wedag (KHD), Giga Media (GIGM), TD Ameritrade (AMTD), and Madeco (MAD). This is just a list of potential ideas, of course, so do your own research.

Will these companies beat the S&P 500 for a fifth year in a row? I’m optimistic, but check back in a year to learn the results.

Author’s note: Thanks to Tim Beyers for help with this column. To follow what Beyers is writing about, click his Twitter feed here.

Disclosure: At the time of publication, the author was long XOM, TS, CLR, KHD, GIGM, AMTD, and MAD, although holdings can change at any time.

Comments

[pmcmullen100:]

Very interesting. Is there a way to test this for past periods?

Feb 14 04:05 PM

[Buy and Hol...:]

MAD looks like a nice dividend play as well. There's a fat $2.45 dividend with an ex-dividend date of March 25. So, buy the stock on Monday, and it's probably going to trade up both Monday and Tuesday. Put a stop order in Tuesday night, because it will likely trade down on the ex date.

Set the stop price at about a buck less than the closing price on Tuesday so that you sell quickly if the likely drop on the ex date comes. And even though you will likely lose a buck on the trade, you'll still make $1.45. On a stock trading at around $7.50 a share, that's a nice profit for holding the stock for just a few days.

Mar 22 11:31 PM