The goal of investing is to pick out winners. There are certain stocks that have a higher certainty of delivering a defined range of returns for investors (as long as you buy the stocks at good valuations).
These winning stocks tend to have:
- earnings stability and consistent earnings growth,
- higher margins against their peers, and
- price growth persistence
If the boxes are checked for all 3 items above, we probably have a winning stock on our hands.
1. Earnings Stability & Growth (Ideally in a Growing Industry)
Aging and growing populations and advances in technology are reasons that the healthcare sector tends to experience stable growth. The juggernaut in the sector, of course, is no other than Johnson & Johnson (JNJ), which has a piece of the pie in the different areas of Healthcare with a Pharmaceutical segment (about 41% of sales), Medical Devices segment (27%), and Consumer segment (14%).
The graph below showcases how stable J&J's earnings are; it experienced adjusted EPS growth every single year since 2000. It's no wonder the company tends to trade at a premium P/E despite having been estimated to grow EPS by only about 6% per year over the next 3-5 years.
The market tends to pay up for J&J stock for its stability and consistent growth. Over the last decade or so, if you bought J&J stock at about a P/E of 16, you would have gotten total returns of about 8.5% per year. That's below the long-term average market returns of about 10%. However, what you get in return is more certainty, more stable earnings, and a smoother ride. As such, I still consider J&J as a winning stock, and it serves as a stabilizer in any conservative dividend portfolio.
2. High Margins Against Peers
Companies in the same industry are subject to similar kinds of challenges. So, if one company is able to consistently get higher margins than its peers, it has some sort of advantage.
The infamous example would be comparing Home Depot (HD) to Lowe's (LOW). While both stocks have delivered tremendous wealth to their shareholders over the long run, HD is time and time again viewed as the higher-quality counterpart.
Since 2007 (we avoid starting from during the last recession, which exaggerates returns), HD has delivered annual total returns of about 14.7%.
In the same period, Lowe's has delivered annual total returns of about 10.4%. Even if it weren't for the recent dip in the stock, LOW would still only have delivered annual returns of about 11.8% in the period.
The graph below shows the operating margins of HD and LOW since 2007. While HD's margin has climbed since the last recession and stayed stable since 2018, LOW's has climbed at a slower pace and started slipping and falling since 2018.
Since Marvin Ellison took over the roles of president and CEO at Lowe’s in July 2018, he has led some major changes, including improvements in the supply chain and technology, which can lead to margins expansion down the road.
So, despite HD earning higher margins than LOW, we're not counting out LOW just yet. In fact, it can be a good candidate for double-digit returns on the recent dip to a fairer P/E of about 18.
3. Price Growth Persistence
Winning stocks are doing something right, which may allow it to experience above-average earnings stability, earnings growth, and higher margins than their peers. Consequently, they tend to have strong price growth persistence, such that even when the stock market or the stocks of its peers go down, they tend to fall less or even rise.
Buying stocks with strong price growth persistence may be a bit counter-intuitive, because, as investors, we are somewhat trained to buy stocks when they're cheap, and we tend to feel stocks are cheap after they have corrected.
Comcast (CMCSA) has strong price growth persistence. Its long-term stock price chart is in an upward trend, and it trades at above its short-term simple moving averages.
Comcast is also backed by stable earnings and consistent earnings growth - partly due to its stock buyback program that reduced the share count by more than 18% over the last decade.
We began recommending Comcast in DGI Across North America a year ago when we noticed the stock was trading at an attractive valuation after a correction. Since our first recommendation, the quality dividend growth stock has appreciated about 29%.
If you have stocks that have earnings stability and consistent earnings growth, higher margins compared to their peers, and price growth persistence, they're probably winners.
If you've identified winners in your portfolio, hold on to them through thick and thin, and you'll be immensely rewarded in the long haul. Oh, and, of course, add to them when they are attractively valued.
Want to learn more about this strategy and get our high conviction winning idea that trades at a good valuation now? Try DGI Across North America for free.
Disclosure: I am/we are long CMCSA, JNJ, LOW. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Disclaimer: This article consists of my opinions and is for educational purposes only. Please do your own research and due diligence and consult a financial advisor and or tax professional if necessary before making any investment decisions.