How to Pick Winning Retail Stocks, Pt. 2

These two data points give me a quick, convenient look at the company's profitability and debt structure. I only want companies that are performing in line or better with competitors and have similar or better debt structures. Those retailers that don't meet the grade get crossed off my list.

I repeat this process for every retailer on my list. That may sound daunting, but after you get the hang of it, things move along quickly.

Three Fundamental Factors

At this point, I'm usually down to two or three solid candidates, but I'm not quite done. I now need to check out long-term growth rate, margins and recent financial performance. Reuters is a good, free source for this information.

For long-term growth rates, I'm looking for rates of growth in sales and in profits that meet or exceed industry averages for a significant time period, which I define as five years. That shows that a retailer can deliver over a significant period and can weather the ups and downs in the retail business, a huge plus because there are many. This is not a stable sector.

Then I look at how my retailer's key margins -- gross margin, operating margin and net profit margin -- stack up. Again, I'm looking for them to meet or exceed industry averages. I want to make sure my retailer is keeping its operations lean and mean. That's especially important in retail, where a basis point or two of margin improvement can be huge.

Now, if my target retailer doesn't shape up on all counts, I don't necessarily eliminate it. It's subjective, but I weigh the factors, with a bias toward growth; if the margins are off, long-term growth could make up for it.

I also want a view of how the company has done recently, so I dig up its latest quarterly financial statements. This gives me a good idea of what's happening near-term. I'm looking for solid top- and bottom-line growth, same-store sales growth in line with historical norms and with competitors' growth, and any new catalysts and changes going forward.