Minervini 4 – Earnings Quality and Leaders

Minervini 4 – Earnings Quality and Leaders

Today’s post is our fourth visit to a popular investing book – Mark Minervini’s “Trade Like A Stock Market Wizard”. We’re going to be talking about Earnings Quality and Leaders.

Earnings quality

In Chapter 8, Mark looks at earnings quality.

  • Higher volumes and higher prices and lower costs (higher margins) are good, everything else is bad.

If sales were strong, was it only because of a single product or one major customer? In that case, the growth is vulnerable.

Or are the surprisingly strong results due to an industry wide phenomenon or an influx of orders from numerous buyers?

Maybe the company is slashing costs and cutting back. Earnings improvement from cost cutting, plant closures, and other so-called productivity enhancements walks on short legs.

The ideal situation is when a company has higher sales volume with new and current products in new and existing markets as well as higher prices and reduced costs.

The worst situation is when a company has limited pricing power, its business is capital-intensive, margins are low or under pressure, and it’s faced with heavy regulation,intense competition,or both.

An example would be the airline industry.

Increasing profits

Increasing profits

Mark also likes to ignore non-operating / non-recurring income, such as that from the sale of non-strategic assets (eg. property).

And he warns against massaged numbers – companies lowering guidance so that they can report a positive earnings surprise (this is more common in the US than the UK).

  • “Kitchen-sinking” is a similar tactic (used by a new management team) to get all the bad news out at once, depressing future expectations.

Similarly, you need to look our for firms that habitually report “exceptional” costs from things like “re-restructuring” or inventory write-downs.

  • Dodgy accounting – like booking revenues from orders that haven’t happened yet – is another issue.

The ideal situation is when a company has higher sales volume with new and current products in new and existing markets as well as higher prices and reduced costs.

Margins

A company with a strong net margin compared with the industry average in the industry has a competitive advantage.

  • Within an industry, net margins can be used to gauge management quality.

A well-run growth company should show consistent improvement in operating margins and net profit margins.

A decline in net margins could be temporary (a short-term rise in raw material costs or temporary inefficiency in production).

  • When net margin declines because prices are dropping as a result of declining customer interest, it’s a lot more serious.

Apple

Apple

From 2003 to 2011 Apple’s stocks price went up by 6000% as its margins expanded from 1.2% to 23.9%.

Stock price reactions

I like to see the stock price react strongly to the earnings report and hold its gains.

For a true super performer, there should definitely not be a huge sell-off that breaks the whole leg of the stock’s upward move.

LuluLemon - post earnings drift

LuluLemon - post earnings drift

Even if you miss the first upward reaction, the post-earnings drift [upwards] can last for some time.

Netflix - Stock gaps on earnings

Netflix - Stock gaps on earnings

What I’m looking for is better than expected earnings along with positive earnings guidance. A company should not only be doing well but be doing better than analysts anticipate.

Inventories

Inventory and accounts receivable analyses can provide a heads-up as to whether business conditions are likely to improve or if the good times are coming to an end.

The amount of inventory is not that meaningful. It’s the trend in inventories versus sales.

Mark quotes the example of Encore Wire and the rising copper price in 2004.

For industries such as manufacturing, the comparison of inventory and sales is crucial. The company could be pushing on a string if inventories are growing much faster than sales.

If finished goods is rising much more rapidly than the raw materials or work-in-progress, product is piling up.

When that inventory is highly depreciable (computers, retail) this could spell trouble.

On the flip side, if raw materials are suddenly building up, this could be an indication that the company believes business will be picking up.

Receivables

Accounts receivable are what the company is owed for sales it has already made.

If receivables are increasing faster than sales, the company is having trouble collecting from its customers.

Inventory build-up

Inventory build-up

Code 33

Mark defines a “Code 33” as:

Three quarters of acceleration in earnings, sales, and profit margins.

Code 33 - three quarters of acceleration

Code 33 - three quarters of acceleration

Such firms usually do well.

  • Of course, we don’t have quarterly reporting over in the UK, so it would have to be three half-years.
Leaders

Chapter nine is about leaders – market-leading companies.

Market leaders are the stocks that emerge first and hit the 52-week-high list just as the market is starting to turn up.

Most of the big money made in bull markets comes in the early stages, during the first 12 to 18 months.

As a bear market is bottoming, leading stocks – the ones that best resisted the decline – will turn up first and then sprint ahead–days, weeks, or even months before major indexes come off their lows.

By the time a big advance asserts itself in the broad market indexes, many of the best stocks may have been running up for weeks in advance.

Tops

Market leaders tend to foretell turns to the downside as well. As a bull market enters its later stages many of the leadership stocks will start to buckle while the broad market averages march on toward their tops.

Typically, a second wave of post leadership stocks start to perform relatively well as money rotates out of the true leaders and into these, or defensive groups (drugs, tobacco, utilities, and food stocks).

Not easy

It’s not easy to buy the leaders at the bottom:

  1. most people will be nursing losses, and not feeling like buying
  2. the media will be predicting the end of the world
  3. leading stocks will always appear too expensive
  4. most investors don’t buy stocks near new highs

Inexperienced investors will be looking to buy a pullback that rarely materializes during the initial leg of a new powerful bull market, which from the onset will appear to be overbought.

Up days should be accompanied by increased volume whereas down days have lower volume.

The list of stocks making new 52-week highs outpaces the new 52-week low list.

Leaders vs Laggards

Leaders vs Laggards

Finding leaders

The stocks that hold up the best and rally into new high ground off the market low during the first 4 to 8 weeks of a new bull market are the true market leaders.

Amazon

Amazon

Look for resilient stocks that hold up the best, rebound the fastest, and gain the most off the general market bottom.

The best stocks make their lows ahead of the absolute low in the market. As the market averages make lower lows, the leaders diverge and make higher lows.

Humana

Humana

Technical themes

Often a technical theme will be present in a market cycle.

A growing number of stocks displaying positive, divergent price behavior during a general market decline can tip you off to where the next group of market leaders may emerge.

You should try to own the top one, two, or three names in the industry in terms of relative performance and earnings power.

Leading on the downside

Just as the leaders lead on the upside, they also lead on the downside. The smart money will move out swiftly at the first hint of slowing growth.

Most stocks experience a relatively severe decline in price after a super performance phase has run its course.

The chances of a superperformer giving back most or all of its gains are high. On average,their subsequent price declines are 50%to 70%.

Leaders tend to top around the same time the general market starts to show signs of distribution.

A bull market is always dominated by at least one sector. The relatively few leading names eventually attract institutional money.

Buying enthusiasm can push their prices far above realistic valuations. As a result, those issues tend to decline the most during the subsequent bear market.

The leaders of the past bull market rarely lead the next rally – fewer than 25 percent of leaders in one cycle generally lead the next.

Conclusions

Today’s chapters have been a bit lighter than the ones we’ve looked at in previous articles.

  • They are packed with stock chart examples, usually from the US and often from decades in the past.
  • The central ideas – check earnings quality and buy industry and market leaders – are pretty simple and intuitive.

I’ll be back in a few weeks with the next two chapters of Mark’s book, which are about charts and primary bases.

Until next time.

Share this with , Google+, Pinterest, LinkedIn, Tumblr, Reddit and StumbleUpon.

Mike Rawson

Mike is the owner of 7 Circles, and a private investor living in London. He has been managing his own money for 30 years, with some success.

Article credit to: https://the7circles.uk/minervini-4-earnings-quality-and-leaders/

Leave a Reply

This site uses Akismet to reduce spam. Learn how your comment data is processed.