Developing a winning strategy for selecting growth stocks is often an arduous task, but an effective research process can make it much easier. No two investors may pick stocks the same way, but it's important to find out what works for you. One way to begin is to look at some of your past winners and identify the process you used to find them. This is a good assignment for any investor, no matter how experienced or successful. So, with that advice, let me explain how I research stocks and how I came to invest in a stock that delivered a huge return. My primary task here at TheStreet.com is to manage the
Breakout Stocks newsletter service. I look for small- and mid-cap companies that are direct beneficiaries of growth trends within the economy. I do not make big-picture bets on large macro trends such as rising consumer electronics sales. Instead, I like to dig deeper and look for the micro trends that can't move the needle for a big company but can easily drive significant growth at a smaller company. This maxim helps me tremendously; using it, I can ignore 95% of the stocks on the market and spend my time looking for the 5% that are showing outstanding growth. With a greatly narrowed stock universe, it is much easier to find what I am looking for. Last year, one of our most successful positions was video-game retailer GameStop ( GME), which rose 125% in 2007, as demand for hot video-game products like the Nintendo Wii console boomed. Now the Wii did benefit retailers like Best Buy ( BBY) and Wal-Mart ( WMT), but given my very bullish outlook for video-game sales, it made infinitely more sense to focus on a stock levered 100% to video-gamers. GameStop was the obvious choice. GameStop became the biggest driver of the Breakout Stocks model portfolio, which returned 13.5% in 2007 compared with 1.4% for our benchmark, the Russell 2500. (Please click here if you'd like to take a free trial of the Breakout Stocks service.) Naturally, not all of the stocks in the model portfolio performed as well as GameStop, but given the solid return of the service, my research process was working nicely. Here is how I research stocks. Once the stock universe has been narrowed, my next step is to observe the world and its markets to examine how they are changing. In recent years, emerging-market economies like China have joined the world's stage; commodity prices have skyrocketed, and technology has advanced in ways few of us could have predicted. I pay special attention to the actions of large, diversified companies. For example, General Electric ( GE) can give investors insight into what is happening in various sectors, including financial services, aerospace and infrastructure. In turn, investors can take that information and look for plays on the stronger segments of GE. The company's infrastructure segment, in particular, has been exceedingly strong but not quite strong enough to offset weakness in financial services. As a result, GE's stock stagnated in 2007, while infrastructure stocks like Foster Wheeler ( FWLT) and Willbros Group ( WG) simply went through the roof. You can often find the strong sectors and weed out the weak ones by examining the individual segments of large, diversified companies. The weak results in financial services at companies like GE were one reason I was significantly underweight financials throughout 2007. At the same time, I always perform extensive research at the company level, placing utmost importance on a company's financial stability, competitive positioning and track record of success. I also place great emphasis on a company's ability to generate upside earnings surprises, which is a key element in growth stock performance.
My bullishness on video games came as a result of a number of factors. First, I liked what we heard about the industry's growth prospects from diversified retailers. We also had other winners in the video-game space, including Activision ( ATVI) and THQ ( THQI), that gave bullish outlooks for industry growth. Our industry research indicated an almost absurd number of attractive software titles due for release during 2007, including Microsoft's ( MSFT) Halo 3, the biggest software title release in years. And in general, we believed that video games would dominate holiday shopping lists, which turned out to be true as the Nintendo Wii became the hottest holiday gift of the year. It's always best, when possible, to do some research in person. And it's often quite easy. Before I invested in GameStop, I checked out their stores. I was very impressed with their retail sales team, which tended to be highly knowledgeable and aggressive. This was not the case with the sales team from Circuit City ( CC). Not only could GameStop employees effectively answer all my questions, they were also cross-selling products and encouraging preorders of upcoming games. I believe this culture was a key factor in GameStop's continued market-share gains. I was also very impressed with GameStop's track record of beating analysts' estimates and improving its balance sheet, along with management's ambitious plans for expansion throughout the world. I also liked the company's foresight in past acquisitions, which gave it dominant market share within the U.S. As I was doing my research, it became increasingly obvious that GameStop had the makings of a home run. With an investment opportunity like GameStop, small investors have an advantage over the big institutions. For example, if a $100 billion mutual fund wanted to allocate 5% of its assets to GameStop at the beginning of 2007, it would have had to buy all the common stock outstanding. But an investor with a smaller portfolio would have little trouble making that type of allocation. While I do not believe that GameStop will perform quite as well as it did in 2007, the company is shaping up for a very good year in 2008. In particular, we believe the Sony ( SNE) PlayStation 3 console will be a very hot item during the second half of the year, which should drive a significant increase in industry sales growth. Plus, as GameStop's sales mix becomes more heavily weighted in software vs. hardware, we expect profit margins to improve substantially throughout the year. GameStop is a selection of
TheStreet.com Breakout Stocks service . Michael Comeau regularly scans the investment universe for breakout stocks like Priceline.com (PCLN) and Rubicon (RBCN) to add to the Breakout Stocks model portfolio .