It's no secret that share price appreciation goes hand-in-hand
with earnings growth.
If only it were that simple.
Screening for companies with the strongest outlooks will only get
you so far.
You might know that Chinese search engine
Baidu (Nasdaq: BIDU)
is expected to deliver +40% compounded annual earnings growth
during the next five years. But so do about 10 million other people
that are watching the stock. That optimism is already priced into
the shares, which trade for about 50 times forward earnings at this
That doesn't necessarily mean Baidu's meteoric ascent is over, but
any future gains are hardly a slam dunk. The surest path is for the
market to rethink (and revise upward) its growth assumptions, which
in this case won't be easy.
The real winners spotted the company's potential back in 2006. They
understood what surging Internet traffic, skyrocketing paid search
revenues and a highly scaleable business model could do long before
it actually played out. Then they held on tight as the shares went
from $50 to $450.
My point here is that it's far more important to focus on the means
than the end.
If the crash of 2008 taught us anything, it's that all those
numbers on a firm's balance sheet and income statement can change
with the financial weather. So I prefer to spend less time
monitoring sales and profits and more time evaluating the
underlying factors that influence them.
If for no other reason, they can give you a critical "heads-up"
that changes (either positive or negative) are right around the
A flash-in-the-pan stock rally can come from anywhere. But
virtually all long-term wealth creation stems from durable
competitive advantages. Companies like Baidu have something that
their rivals just can't emulate -- and that's why they've been so
These advantages form economic moats that help businesses defend
their territory from marauding competitors. The wider the moat, the
longer a company can hold rivals at bay and continue generating
outsized returns for shareholders. Warren Buffett won't even sniff
at a company without a moat to protect its returns on capital.
One of the most basic rules of stock analysis is that it can be
misleading to compare the profit margins of companies in different
sectors. After all, a grocer pocketing 5% of every dollar in sales
might be best-in-class, while a biotech firm with margins of 25%
could be the group's laggard.
Most experts will tell you that it's best to compare grocers to
other grocers and biotechs to other biotechs. And that may be true.
But they're missing the bigger picture. Instead, ask yourself this:
Why can some industries maintain profit margins five times greater
The answer lies in the "Five Forces" diagram below, which was
developed by Harvard Business Professor Michael Porter.
Let's briefly examine each of these forces:
- Competitive Rivalry: This refers to the competitive intensity
of the industry itself. Obviously, concentrated industries with
only a handful of players tend to be less competitive and more
profitable than fragmented industries (like fast-food) where
hundreds of players try to undercut each other.
- Barriers to Entry: Success always invites competition. But
some industries are harder to crack into than others. It's
usually best to look for industries with high barriers to entry
that shut out would-be competitors. These barriers can take the
form of anything from government regulation to capital
requirements. Anyone can start an online retail business, but
coming up with the billions needed to buy a fleet of cruise
liners is a different story. This is why barriers to entry can be
so valuable -- and why, as I tell my readers in this month's
, shares of companies like
Stericycle (Nasdaq: SRCL)
Bally Technologies (
have exploded for more than +1,000% during the past 10 years.
- Threat of Substitutes: Products or services that are easily
replaceable can't command top dollar -- customers will simply
switch to option "B". Therefore, industries with no close
substitutes are preferable. Computer makers, for example, can't
get too far without semiconductors.
- Bargaining Power of Suppliers: The first three factors were
horizontal, but the last two are vertical. If you are making
bicycles, and there's only one tire supplier in your area, then
you have no choice but to buy from them. They hold all the cards.
But if there are a half dozen tire makers, you can negotiate a
better deal -- particularly if you're the biggest purchaser on
- Bargaining Power of Customers: In a monopoly , there are many
buyers, but just one dominant seller. The flip-side is a
"monopsony," where there are many sellers, but just one buyer
(like specialized defense equipment sold to the government). In
this case, it's the buyer that calls all the shots.
We've barely scratched the surface here -- but you get the idea:
a company's profitability and stock are both governed by the
competitive framework of its industry.
All of these forces interact to determine whether a specific
industry is highly attractive to investors, or screams, "stay
We see these forces at work all the time. Sometimes suppliers must
cave to the demands of a powerful buyer like
. Other times it's the buyers that must yield to the demands of the
seller -- like when
BHP Billiton (
dictates iron-ore prices to steelmakers.
There is a symbiosis to any business relationship. The buyer needs
the seller's wares, and the seller needs the buyer's money. But,
the balance of power always favors one party over the other. If you
can determine who has the upper-hand in these relationships, you'll
be a step ahead of the crowd.
Editor: Market Advisor, The ETF Authority
P.S. While the five forces above can launch a stock over the
long haul, there's only one force -- the most powerful of all --
that can send it to the moon in a matter of days. This driving
force is the reason that InterDigital (Nasdaq: IDCC) shot from
$4.50 to $82 in just six weeks... and it's the reason that 54 out
of 62 of our open Market Advisor picks are up today. What is this
"driving force" -- and how can you get on the next rocket stock
before it takes off? Answers here.
Disclosure: Nathan Slaughter does not own shares of any security
mentioned in this article.