Finding Your Winners

Earlier, we learned that emotions fear and greed drive price action in the short-term. In this lesson, you are going to learn what drives price action over the long-term (years).

Finding good, strong companies makes trading much easier. Good companies stock price is more likely to increase than that of a poor company. If a company’s share price is more likely to rise, than there’s a higher chance your trade will be successful. 

How to Find Good companies?

Become aware of trends around you. Are people eating a lot of fast food (MCD), talking about the hottest television series (NFLX), or using a new messenger app at work (WORK).

When I first moved to Chicago in Fall of 2018, I noticed two trends coming from a small, midwestern city. Everyone on my commute, walking sidewalks, and working out was using AirPods (AAPL) and wearing Lululemon (LULU). 

Another trend I have noticed in the past year is young people are becoming increasingly more aware of their health. This can be seen in low-calorie alcoholic drinks such as WHiteclaws and Truly’s and every girl on Instagram trying to be a fitness model, EXPENSIVE workout studios such as SoulCycle and Orange Theory, and increase in hiking interest and areas focused around outdoor activities such as Denver. Celsius Energy Drinks (CELH) has rebranded in recent years to be a healthy, low-calorie/sugar fitness caffeinated energy drink. The drink contains only 10 calories per serving and 0g added sugars vs Monster’s Energy drink containing 200 calories and 50g added sugars.

Another great example has been the uptick of social media and ad spend. Just check the prices of Snapchat, Facebook, Twitter, and Pinterest.

Quality brands are another good sign of a good company. Quality brands tend to retain customers.  AAPL has one of the strongest brands ever created. There’s a good chance if you have an iPhone you also have a Mac, iPad, Apple TV, Apple Watch, or AIrpods. Funnily enough, if your iPhone malfunctions after 2 years, I’d bet 9/10 will buy another iPhone. That’s strong branding. 

Strong branding’s marketing is often a result of word of mouth. Have you ever spent some time around someone who has a Peloton PTON? I’m sure they let you know how great it is and recommended you come over and take it for a ride or buy one yourself. 

Tesla is another company with a strong brand. Ultimately, a quality product and customer service often leads to a strong brand and the stock price will certainly reflect that eventually.

The above “metrics” are all subjective, therefore, it’s important to use fundamental analysis to find good companies. One of the most popular metrics to value a company is price-to-earnings ratio (P/E). A high P/E suggests that a company is overvalued and price is currently too high based on said company’s earnings. Many would suggest that P/E greater than 20-25 would make a company overvalued and avoid buying. However, in today’s technological driven world, company’s have an ability to scale and market so fast along with insanely high margins that P/E ratios are essentially useless. Many investors suggest that these “expensive” companies grow into their temporarily high valuations. 

Valuing companies based on P/E would’ve been an expensive lesson in the 2010s missing out on companies such as Netflix (NFLX) which saw a P/E greater than 600.

Over 10 years, NFLX increase by 1,290% compared to the S&P 500’s 223.9%. A measly $1,000 investment in NFLX would be worth $13,920 today. Looking at NFLX’s P/E chart, NFLX’s P/E was rarely below 70, most definitely scaring many investors away. 

For these reasons, if there was one metric to analyze, it’d be increasing sales revenue. Increasing revenues Y/Y by at least 20% is the benchmark today. A 20% compounded annual growth rate leads to a revenue increase of 519% over the course of 10 years.

The above chart shows a strong correlation between revenue and share price growth. While EPS may look a good correlation as well, if you look closely, EPS growth was mostly flat from 2012 to 2017. Tracking revenue growth, you could’ve forecasted a strong future earnings and beat the crowd into the company. 

Taking a look at Square SQ chart below you see negative earnings growth despite share price soaring with revenue. 

Contrarily, looking at AT&T T you see revenue growth of just 37% over 10 years or just 3% CAGR each year. Note, T’s significant underperformance.

Walt Disney essentially matched the performance of the overall market making it a poor choice. Revenue growth at the beginning of 2020 was on pace for 40% over 3.5 years may sound good but is till just 10% Y/Y. Matching mostthe S&P 500 perfomracne. Remember the benchmark we are looking for here is 20%.W

Walmart is what many value investors would consider safe and valuable with its modest valuations. Yet it still underperformed the S&P 500.  The biggest lesson to take from this, is that quality is never cheap. You will always pay a premium for the  nicest clothes, cars, and food so why would the best companies in the world be any different?