My 7 Signs of a Winner

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 3,558 companies on U.S. exchanges with a market cap of $200 million or greater, only 24 passed the screen.

Five to consider
It's very interesting to see both MSC Industrial Direct (NYS: MSM) and W.W. Grainger (NYS: GWW) on the list. Both support the maintenance, repair, and operations (MRO) market for manufacturers, industrial, and service companies. They are among the only companies with national reach in a highly fragmented market, and I expect them both to do well and grab market share as the economy recovers.

Software leaders Oracle (NAS: ORCL) and Pegasystems (NAS: PEGA) also made the cut. They aren't quite as similar in their fields as MSC and Grainger, but it's close. Oracle is the 500-pound, $150 billion gorilla with extremely large reach in database systems, middleware, and other business-related software. Pegasystems helps companies automate, track, and analyze complex tasks -- such as landing planes at Heathrow Airport. Our own David Gardner sees huge upside potential both in Pegasystems and this industry.

Seadrill (NYS: SDRL) operates an ultra-deepwater drilling fleet. It has 47 rigs in operation, with another 12 expected to go on line in the next couple of years. One key advantage it has over rivals is the age of its fleet -- it's the youngest in the industry, and that means it's spending far less on maintenance than competitors.

Of the five I just mentioned, I believe all but Oracle can qualify for the last metric on the screen, "out-of-the-way success." But given Oracle's extreme competitiveness and a forward P/E of 12, I'd hardly call it overhyped and overvalued.

Tracking time
Those are just a few that passed the screen, but I'll post the full list on my Rising Star 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 thisarticle was published You can keep up with Rex's screening exploits via Twitter. Of the companies mentioned here, he owns shares of MSC Industrial Direct. The Motley Fool owns shares of Oracle. Motley Fool newsletter services have recommended buying shares of Seadrill, Pegasystems, and MSC Industrial Direct. 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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