Find Stocks Built for Speed -- and Acceleration - TheStreet

Let's say the economy and the financial markets are headed for the "soft landing" that the stock market currently seems to be anticipating.

That would mean that the

Federal Reserve has found just the right medicine to prevent inflation from spiking without killing all economic growth. The fear that the Fed wouldn't be able to pull that off has been a damper on this market for most of the last six months. And, in my opinion, the hope that it has succeeded accounts for the modest rally that we had in August.

This scenario also argues that, going forward, an investor would like to be overweighted in stocks that are growing earnings faster than the market average. That's because the economy will grow more slowly over the next six months than it did over the last half-year, if the Fed has indeed played its role to perfection. That would make earnings growth harder to come by for the average company, which means that stocks of companies able to grow earnings significantly above the market average will be scarcer, and hence more valuable.

In other words, this is a good time to be using growth strategies to pick stocks for your portfolio.

Follow the Bouncing Growth

In my last column,

5 bargain stocks according to GARP, I laid out the case for using a growth-at-a-reasonable-price (GARP) investing style. Thanks to worries about inflation and interest rates over the last six months, an investor can currently find literally hundreds of stocks that are projected to grow earnings faster than the

S&P 500

this year and next, but that are still trading at a lower PEG (

price-to-earnings ratio divided by earnings growth) than that market index. In other words, an investor can pick up unusually high future growth right now at an unusually low price by using this strategy.

But that's not the only growth-stock investing style I'd recommend right now: I think an earnings momentum strategy also is likely to outperform the market over the next six to 12 months. What's an earnings momentum strategy? At its simplest, it says: "Of two stocks with an equal annual growth rate, pick the one where growth is accelerating quarter by quarter."

Let's say you've found two stocks that you're weighing as potential buys. Both are projected to grow earnings by a very impressive 39% over the next 12 months, and after doing your own due diligence, you agree with those calculations. The stocks are in pretty much the same industry and trade at the same price-to-earnings ratio. But you've got only enough cash to buy one. Which do you buy?

Obviously, the one with earnings momentum. A stock with 39% annual earnings growth composed of a 10% quarter, followed in order by a 9% quarter, a 8% quarter and a 7% quarter is likely to trace a downhill price path over the course of the year. A stock that has started with 7% quarter-to-quarter growth, and moved successively up to 8%, 9% and 10% growth quarters, is likely to end the period well above where it began. It's only logical that a stock showing accelerating growth is a better buy than one where the rate of growth is declining.

Outpace Your Expectations

There's more to the value of earnings momentum investing than that, however. In fact, the degree of outperformance delivered by a stock with accelerating earnings growth is far above what an investor might logically expect.

Why is that?

  • First, in the business world, success tends to breed more success. Now, it may be dangerous to believe that flipping 19 heads in a row improves the odds that the next flip of a coin will result in another heads. But with stocks, past good earnings news does increase the likelihood of future good news. The business developments that produce accelerating growth -- the introduction of successful new products, the addition of important new customers and the completion of more efficient new factories -- build momentum over time. A new product may bring in only $5 million in its first quarter, then $10 million and then $30 million. New customers serve as references that make the next sale easier. A more efficient factory allows a company to cut costs, undersell the competition and then lower prices (or increase margins), as the new business gradually fills the factory to capacity.
  • Second, academic research has shown that earnings momentum strategies can count on a psychological boost to go along with the "success breeds more success" business truth. Investors in general -- and analysts in particular -- are reluctant to increase their projections for a company's growth. It apparently takes a lot of evidence to convince them that a company that has been growing at 10% a year has suddenly started to grow at 15%. I think the evidence conclusively shows that earnings projections lag the improving fundamentals at a company with earnings momentum. And even when analysts move their projections in the right direction, bumping an estimate up by a penny or two, they typically capture only part of the coming increase.

Earnings momentum investing styles begin by screening for indicators that these two tendencies may be working for a stock. To find evidence of a change in business fundamentals that is going to lead to a virtuous cycle of success, earnings momentum investors look for stocks that are getting earnings estimate upgrades from analysts. To find stocks where analysts' expectations still lag improved fundamental performance, those same investors look for stocks that have reported earnings above analyst expectations in recent quarters.

Now, to the Names

I've built a

MoneyCentral

finder screen for earnings momentum stocks, combining those two indicators with some reasonably hefty requirements for basic growth: On the earnings momentum front, I've looked for at least a 3% earnings surprise in the last quarter, and for an increase in analysts' estimates in the last quarter (and no decrease in the last month). On the pure growth side of the story, I've asked for a minimum 15% earnings growth in the most recent quarter and most recent year, and projected growth of at least 20% next year as well. I've also required 10% revenue growth year to year. To make sure that the stocks have some price momentum, I've required a positive price movement in the last month. To insure adequate liquidity, I've set market capitalization at $250 million or better.

When I ran that screen on Aug. 30, it gave me a list of 79 companies. Jubak's Picks --

Texas Instruments

(TXN) - Get Report

,

America Online

(AOL)

,

Nokia

(NOK) - Get Report

and

Cisco Systems

(CSCO) - Get Report

-- all showed up in the top 20. When I adjusted

Nortel Network's

(NT)

earnings to remove one-time charges for acquisitions, that stock made the list as well.

As that last adjustment shows, a screen like this is only a starting place. And if you dig further into the numbers for these five stocks, three of them show negative developments that bear watching. An earnings momentum stock is supposed to show an accelerating earnings growth rate from quarter to quarter. At some point, since growth rates don't increase forever, that acceleration will stop. And while earnings will continue to grow, they'll grow at a slowing rate. At its most disciplined, an earnings momentum strategy says, "When the acceleration stops, sell the stock."

And that's exactly what I see when I look at the numbers for Cisco Systems, Nokia and America Online. Cisco, for example, delivered 60% earnings growth in the July 2000 quarter. For the October quarter, analysts are looking for just 41%. Even if Cisco delivers the same 7% surprise that it turned in for the July quarter, earnings growth will slow to about 50%. That's clear deceleration. Nokia is facing a similar problem with its September quarter. The company has told Wall Street to prepare for a quarter that's essentially flat with the same quarter of 1999. That would be a huge drop in earnings growth from the 46% Nokia delivered in the June quarter. America Online's earnings growth is projected to drop from 100% in the June quarter, to 70% in the September period.

While I'm not willing to sell three core technology holdings like Cisco, Nokia and America Online on the basis of a single quarter, these numbers do send up important warning flags for me. I think it's time to examine these "must-own" stocks in more detail and see whether they still fit that bill. I'll do that in a series beginning three columns from now, on Sept. 12. In the meantime, I'm also going to stick them in a mental compartment in

Jubak's Picks

called "special situations" -- the last investing style that I'll look at in the five-part style series that will end with my Sept. 8 column.

Since I can't really justify these three stocks as earnings momentum plays, I'm now light on that style. What looks especially attractive among the new names turned up by my earnings momentum screen?

Names to Grow With

My top pick from the list would be

Nvidia

(NVDA) - Get Report

. The company beat estimates by 8% in the July quarter, and analysts have been scrambling to catch up ever since. Although they've raised estimates by 3 cents to 31 cents a share for the October quarter in just the last month, I think the projections are still low. The company has introduced the GeForce2 MX, the first graphics processing unit to target the mainstream desktop market with a low-cost, low-power design, and the new GeForce2 Ultra, currently the fastest 3D graphics chip on the market. According to

Mercury Research

, Nvidia's unit share of the total desktop market climbed three percentage points to 25% in the recent quarter, and its share in the desktop standalone processor market rose 10 percentage points to 35%. I'm adding the stock to Jubak's Picks with a target price of $98 a share by December 2000.

To make room for Nvidia, I'm dropping

Citrix Systems

(CTXS) - Get Report

, a former earnings momentum pick. The addition of Nvidia still leaves me two picks short on the earnings momentum front, but I don't have another sell candidate immediately at hand. So the next four earnings momentum "best bets" from this screen will have to go into a watch list for the time being.

Into that watch list go two chip stocks,

Xilinx

(XLNX) - Get Report

and

Altera

(ALTR) - Get Report

, which are riding the surge in field programmable chips that cut time-to-market for customers developing new products. I'll also watch

Polycom

(PLCM)

, a maker of audio- and video-conferencing products, which is moving aggressively onto the Internet, and

Calpine

(CPN)

, an independent power producer that now operates plants in 11 states.

All these companies are riding strong fundamental trends that should produce accelerating earnings. They certainly bear watching as we move into a period when earnings growth may be getting just a little harder to achieve for the average company.

At the time of publication, Jim Jubak owned or controlled shares in the following equities mentioned in this column: America Online, Cisco Systems, Citrix Systems, Nokia, Nortel Networks, Texas Instruments and Wind River Systems. He welcomes your feedback at

mctsc@microsoft.com.

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