Welcome back to the After Hours Book Forum. Today we begin our discussion of The Little Book That Makes You Rich by Louis Navellier.

Louis Navellier is not a new kid to the field of growth investing. He has been publishing a newsletter since 1980, gracing us with both his wit and wisdom on investing.  On the surface, he's just an ordinary guy. In the back room, he has created an intricate formula for reaping extraordinary gains from the stock market. The Little Book That Makes You Rich is written in an uncomplicated style that has made this one of the most popular books in the little book series.

In chapter one, Navellier reveals eight fundamental factors that he claims have the most influence on a company's stock price. Which of the factors do you feel are the most critical in driving a stock's performance?

Sheryl Sostarich

Ssostar@comcast.net

I am more of periodical reader than a book reader, but I am going to read this book.  Afterall, it is a small book.  I know I can do it.

I have heard Navellier speak a view times (a regular at the Money Show and AAII conventions).  His talks have a lot of self-promotion that you have to tolerate, but he seems to back up with what he preaches.  He impressed me; and that is no small task. His Blue Chip Growth newsletter (per Hubert's) has been very successful as well.

There is a very good "primer" on his eight fundamental factors in article Mr. Navellier wrote in the January 2008, AAII Journal.  For those that might get that magazine.

Louis Navellier is skeptical of pundits who claim that it is one factor, be it price-to-earnings ratio or price-to-cash flow, that allows them to consistently pick winning stocks. Why does he disagree with that approach to stock selection?

Navellier has identified eight fundamental factors that drive superior stock performance. In a volatile market such as we are experiencing, what are the advantages of understanding the business model of a company? Why can it be dangerous to try to pick a winning stock based on a quick glance at a company chart?

Sheryl Sostarich

Ssostar@comcast.net

The “magic-bullet” method or other un-informed stock buys in a volatile market is asking for a poor returns in my opinion. All eight of his variables reflect the financial health and growth of the company. To me, if these variables look good for a company during hard times (during a recession for instance) then it would suggest the company is doing something right and is probably gaining market share. When the economy and market turns around there is a good chance that the company’s earnings can take off. And as they say – prices will eventually follow earnings.

Louis Navellier says that there are eight fundamental factors that affect a stock's performance. I would like to look at each factor in the course of the next three weeks. I hope that you'll jump in with your comments too. The first of the eight fundamental factors is earnings revisions.

Earnings revisions are generally good for stock prices if they are upward and negative for stock prices when they are downward. There is no better feeling than to have one or several analysts raise their earnings target for a stock I own.

I am curious to know how the analysts come up with their predictions? After all, analysts are only human and can make good or bad predictions the same as I can. Do they use a discounted cash flow model? Do they make predictions based on company guidance? Or do they use a less scientific method in making the guesses they do?

I also like to know the track record of the analysts who follow a stock I own. I check on these experts once a year by reviewing the list of top analysts that is published in the Wall Street Journal.

Before the SEC passed Regulation Fair Disclosure, the favored institutional investors knew about earnings revisions a day or two before the lowly retail investor like myself got the word. By the time I could react to the news, it was priced into the stock. I think it's a good thing that all investors learn these predictions at the same time, how about you?

Sheryl Sostarich

Ssostar@comcast.net

<< The first of the eight fundamental factors is earnings revisions. >>

> Earnings revisions are generally good for stock prices if they are upward and negative for stock prices when they are downward.

... however, it is an open admission that previous forecasts were wide off the mark regardless if the revision was up or down.  David Dreman's book documents a study that was done and the margin of error for analyst forecasts are large.  But then one could argue that the world is not static and events that unfold may require revision in previous forecasts/assumptions.

Bakul

I made a post on this board last night but I lost it.  Let me try again.  Navellier says that analysts' main concern is not getting fired.  And no one ever got fired from making revisions that were too low.  If an analyst revises upward, they have to be very confident in that revision because their job depends on it.

He also said that, due to the herd mentality, if one analyst sticks his neck out, others tend to react to it by following suit.

Last night I went to Yahoo and looked up LOW.  On the Analyst Estimates page, they cover revisions.  I don't know how to read them, for sure, but it looks to me that, in the last 30 days, there was one upward revision and 4 down.  Interesting.

Oh yes, to Armin's question:  Navellier measures revisions over the last month. 

Lynn O.

Armin Fields has asked how far back do we go with earnings revisions, one quarter, one year, or five years? I believe you might be confusing earnings revisons with earnings restatements. Louis Navellier is talking about earnings revisions, that is, a change in an analyst's earnings estimate because of higher or lower expected product sales, FDA approvals, acquisitions, repayment of debt or other factors that would cause earnings to be higher or lower than previously forecast. Earnings restatements pertain to past results. Earnings revisons pertain to future results.

Sheryl Sostarich

Ssostar@comcast.net

The second fundamental factor affecting a stock's performance is earnings surprises.

Earnings surprises are particularly powerful because growth stocks are priced based on investor expectations of future earnings. Analysts are human and do plug figures into their complex models and formulas that cause them to over or under estimate a company's performance.

After the dramtic pullback in technology stocks in the late '90s, analysts have tended to be more conservative with their earnings forecasts. This does not imply that their predictions are any more accurate. In this age, it is quite common for an analyst to forecast a range of estimates rather than select a target estimate.

Companies that surprise in one quarter are more likely to surprise again in the next quarter. This has a powerful impact on future forecasts and stock valuations. Do you like a target estimate or do you like a range of earnings estimates?

Sheryl Sostarich

Ssostar@comcast.net

In addition to taking long positions in stocks, I also trade options. With stocks, I take a long position with the conviction that the stock will trade higher as the company grows its business. With options, I sell puts or calls with the conviction that my target price will be attained by a set time. Although a range of estimates gives an analyst more leeway for error, I prefer a target estimate.

What I have noticed from companies that do provide guidance is that they tend to underestimate their growth. Apple Corporation is a classic example. The company is very conservative with quarterly guidance. And when they exceed guidance, they are hopeful that investors will react positively to the surprise and bid up the shares. Buyer beware, the reaction is sometimes exactly the opposite.

There is another hurdle that can completely overshadow quarterly results and that is the earnings outlook. Apple beat the quarterly Street estimates but tempered its outlook and investors reacted negatively by selling their shares. Oh, and if you haven't noticed, stocks drop at a lot faster rate than they rise.

Sheryl Sostarich

The third fundamental factor affecting a stock's performance is sales growth.

It seems obvious that investors would want to own companies with quarter over quarter sales growth. Steadily rising sales are a good sign that a company has a product or service that is in high demand. I prefer to own companies that make consumable products that are purchased again and again.

Slowing sales growth, on the other hand, is a red flag for me. When everybody has a flat screen TV or a mobile phone, chances are that steep markdowns won't even move these products off the shelves. When a new technology replaces an old technology, as digital imagery did with film, it was the only warning I needed to go in search of a replacement stock for Kodak.

Sheryl Sostarich

The fourth fundamental factor affecting a stock's performance is operating margin expansion.

Operating profit is what a company earns before it makes interest payments and pays income taxes. Rising operating margins are a good sign of greater efficiency.

I like this variable because it is what it is. Operating margin is very difficult to manipulate under the standard rules of accounting. It gives us a sense of how good a company is at making money and ultimately, at creating shareholder value.

The decision by a retailer to close one of its poorly performing stores might create a temporary spike in margins but the emphasis is on temporary. The better way to expand margins is to sell more of your product at a lower cost than your competition. It's not enough to make a better mousetrap, you must sell more mousetraps than the competition.

Sheryl Sostarich

The fifth fundamental factor affecting a stock's performance is free cash flow.

Free cash flow is what a company earns after paying its capital expenditures. The cash flow statement tells an investor exactly how a company has spent its cash for the quarter or the full year -- to pay down debt, to expand its facilities, to buy back shares, or to pay a dividend. A company with negative free cash flow has few options other than to borrow money or sell shares in the open market.

Companies with a high cash burn rate are generally not good investments. We learned this lesson the hard way in the '90s with Internet start-up companies. Most of those companies couldn't hang onto a dollar of revenues. Most of those companies aren't in business anymore.

Free cash flow is a variable that we should pay more attention to. Look for companies that are adding to their cash reserves.

Sheryl Sostarich

> Free cash flow is a variable that we should pay more attention to. Look for companies that are adding to their cash reserves.

... and hopefully, the cash accumulation on the balance sheet can be invested in the business at rates above the cost of capital to generate shareholder value, else I'd like management to (1) deleverage the balance sheet by reducing debt (i.e. assuming there is long-term debt in its capitalization), and/or (2) buy back shares, and/or (3) pay dividends.

Bakul

The sixth fundamental factor that affects a stock's performance is earnings growth.

Earnings growth is reported every quarter and is quantified in the income statement as earnings per share. Earnings per share is total profit minus any preferred stock dividends divided by the total number of shares outstanding.

The key is to invest in companies with sustainable earnings growth. We like to see earnings growth advancing in lock step with revenue growth.

Slowing or declining earnings growth is often a telltale sign that a company is losing its competitive edge. Investors who fail to monitor their portfolio stocks often end up riding a losing position lower and lower.

Sheryl Sostarich

The seventh fundamental factor affecting a stock's performance is earnings momentum.

Companies that grow their earnings at a steady clip are likely the ones getting all the media attention. As more and more investors learn the story, the price rises exponentially.

Beware a stock that has been bid to lofty highs. The surest way to underperform the market is to overpay for growth stocks. It's only a matter of time before the momentum buyers sell out and move on to the next headline company.

Sheryl Sostarich

The eighth fundamental factor affecting a stock's performance is return on equity.

Return on equity is a ratio that tells me how well a company is using the dollars I've invested in it to boost my investment return. It is calculated by dividing net income by shareholders' equity. This metric appears in section 2B of I-Club's Toolkit software.

Return on equity is a measure that should be used to compare a company against other companies in its industry. It is inappropriate to compare the ROE of a consulting firm with the ROE of a steel manufacturer because the steel manufacturer has much higher costs of capital and thus a lower return on equity.

Sheryl Sostarich

> It is inappropriate to compare the ROE of a consulting firm with the ROE of a steel manufacturer because the steel manufacturer has much higher costs of capital and
> thus a lower return on equity.

This begs the question of why should one invest in businesses/industries that generate low ROEs?  It would be nice to know what might be the compelling reasons to do so. Also, how low is low .... and what is an acceptable ROE? I hope the author addresses these issues.

Bakul