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Massive Gains Flow from the Interaction of Two Factors

Profit growth is an obvious source of potential stock market gains.

There are, however, numerous examples of companies that did extremely well while their share prices did not. In most of those cases it was because the stocks were so richly valued already that P/E compression stole all the upside.

Here are just a few examples of great EPS growth accompanied by flat to down, multi-year stock performance.

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Wal-Marts' (WMT) multiple contracted from 35.3 to 10.4 despite 145.8% overall profit growth. That made it an incredible bargain last summer. It even sported a 3.15% yield at the August low.

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Iconic Coca-Cola (KO) shares were just too highly priced in late 2000 for investors to obtain good forward returns. The company did fine with almost 85% in earnings growth from 2000 - 2009.

After a 68.2% drop in P/E; KO represented extraordinary value in early 2009. Their shares yielded 4.06% if you caught the exact low.

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High-quality, but lesser-known, Waters Corporation (WAT) was so well liked in 2000 that the shares peaked at a ridiculous 85x multiple. At the March 2009 nadir these same shares sold for under 9 times earnings. That was pretty amazing as the company had more than tripled its EPS over the previous eight years.

In each of those three examples the fine performance of the underlying companies failed to reward shareholders because P/E contraction more than offset the profit gains. That is why you need to avoid paying in advance for even the best projected growth rates.

Two bad things can happen if you pay too much when you buy. The expected growth might not occur due to company specific factors: think Research in Motion (RIMM) or NetFlix (NFLX).

Or...Profits may grow as expected but a falling multiple might wipe out any benefits to shareholders; think Chipotle Mexican (CMG) or Green Mountain Coffee Roasters (GMCR).

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Chipotle Mexican Grill shares have gone nowhere for a year despite nicely improved EPS.

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Green Mountain's stock price is well below its year ago level even though earnings are now much higher.

How do you make outsized gains as a shareholder then?

Buy stocks of companies you think will grow earnings and see multiple expansion.

Note the shareholder returns from WMT, KO and WAT since the low points detailed in the first section of this article. Profit gains were far outpaced by each stock's total return as P/Es increased.

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Predicting future results is never an exact science. Avoid paying in advance (read: High P/Es) for uncertain gains. This removes a large risk factor.

Buy shares of solid companies when the fundamentals are strong but the stocks are weak. This positions you for the biggest potential gains while curtailing downside.

Don't expect to see much analyst enthusiasm for the shares you're buying. That will only come later, after the stocks have already moved up.

Source: Long-Term Capital Appreciation Depends On Confluence Of Profit Growth And Valuation