Are These Stocks Ready to Run?

This article is part of ourRising Star portfolios series.

One of the major goals of my Rising Star portfolio is to introduce and explain the various screens I use to find great stocks. I'll be running each screen at least monthly. Plus, in pure Moneyball fashion, I am now tracking and scoring each so we'll know exactly what's working and what's not. More on that in a moment.

In the batter's box today: my "7 Signs of a Winner" screen.

The windup...
This particular screen was born out of my work with Motley Fool co-founder Tom Gardner for the Motley FoolHidden Gems service. Tom is always studying winning and losing stocks in order to learn how to better find the champions and avoid the dogs -- and I help him as best I can. A few years ago, we studied all of the Hidden Gems winners to find out what they had in common. We found that many of them shared these seven traits:

1. Double-digit rising sales: We view this as one of the most telling indicators of a real growth company. We love earnings growth as well, but earnings are too easily manipulated. Revenue growth, however, is a pretty pure marker of rising demand and pricing power.

2. Rising free cash flow and book value: While earnings can be fudged, cash is where it's at -- and great businesses generate lots of it. A company that's growing both its free cash flow and book value is on the right track.

3. Improving margins: The ability to take in more and more profit from each dollar of sales indicates competitive advantages and efficient management.

4. Rising return on equity: We use ROE as a decent proxy for how well a company allocates capital -- what Warren Buffett calls the most important aspect of management.

5. Insider ownership: This one's no surprise to all you veteran Fools out there. As shareholders of a company, we are part-owners of the business, and we'd like a significant portion of management to be our co-owners. That way, there's more incentive for them to act in our best interests. We look for ownership of 5% or more.

6. Regular dividends: Research indicates that dividend-paying companies tend to be better at managing capital and growing earnings. We feel that the pressure of making quarterly cash payments forces a certain discipline on managers and deters them from such destructive habits as "empire building" -- that's when companies in search of something to do with their cash start making less-than-ideal acquisitions.

7. Out-of-the-way success: Many big winners come out of relative obscurity and are never media darlings or hot IPOs.

...and the pitch!
Armed with that information, the natural question to ask is, "How can I find companies that meet these standards?" Well, by screening, of course! Armed with my awesome Capital IQ screening tool, I looked for companies with more than $200 million in market cap that met the following criteria over the past 12 months:

  • Total revenue growth of 10% or better.
  • Free cash flow growth greater than zero.
  • Book value growth greater than zero.
  • Net margin growth greater than zero.
  • ROE growth greater than zero.
  • Insider ownership at least 5% or better.
  • Dividend yield greater than zero.

The only thing I can't screen for is out-of-the-way success, but if I feel a stock is overhyped and overvalued, I won't consider it for my portfolio.

Of the 3,571 companies on U.S. exchanges with a market cap of $200 million or greater, only 42 passed the screen.

Coca-Cola (NYS: KO) made the cut, further confirmation that this great American brand should be considered for almost any portfolio. It has also passed my "Corporate El Dorados" screen -- which seeks enduring companies that can provide solid returns for decades -- as well as my safe high yielders screen. This was the first stock purchased for my Rising Star portfolio.

While Coke is large and safe, Hercules Technology Growth Capital (NAS: HTGC) is small ($428 million market cap) and much riskier -- but of course that means a higher potential return. The firm provides capital to companies at various stages of their life cycle. The kicker, however, is Hercules' herculean 9% dividend yield. As a business development company that has elected to be taxed as a regulated investment company, it distributes at least 90% of net ordinary income to shareholders in order to gain certain tax advantages. Be aware, though, that the yield can fluctuate greatly.

Much like Berkshire Hathaway, Leucadia National (NYS: LUK) is a collection of investments and operating units. Ian Cumming and Joseph Steinberg have been running the show since 1979 and own a combined 18% of the company -- over $600 million worth each! Tom Gardner sold Leucadia in Motley Fool Stock Advisor after a 135% gain on valuation concerns. Prospective buyers should consider that, along with the succession plan for Cumming and Steinberg (who are 70 and 67, respectively), before taking the plunge.

Pegasystems (NAS: PEGA) is still an active Stock Advisor recommendation, however. It makes software for automating, tracking, and analyzing complex tasks -- such as handling air traffic at Heathrow airport. David Gardner sees strong growth potential into a largely untapped market.

MercadoLibre (NAS: MELI) , meanwhile, is a core stock in Motley Fool Rule Breakers. The so-called eBay of Latin America is a huge name in a number of fast-growing economies with a still-low Internet adoption rate.

Tracking time
Those are just a few that passed the screen, but I'll post the full list on my Rising Stars discussion board. Also, every new company will be entered as a "buy" on the 7 Signs Motley Fool CAPS page, and those dropping off the screen this month will be sold in the CAPS account. That doesn't represent the way we would normally buy and sell stocks; you can see that in my actual portfolio. But this methodology should let us use CAPS to give us an idea of the effectiveness (or lack thereof) of the screen.

If you're interested in any of the companies I discussed, add them to your very own watchlist by clicking below.

At the time this article was published You can keep up with Rex's screening exploits via Twitter. Rex owns shares of Berkshire Hathaway. The Motley Fool owns shares of Berkshire Hathaway and Coca-Cola. Motley Fool newsletter services have recommended buying shares of Pegasystems, Coca-Cola, Mercadolibre, and Berkshire Hathaway. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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