The Winning Ways of Winning Stocks

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 for you monthly. Plus, in pure Moneyball fashion, I am now tracking and scoring each one 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 3,584 companies on U.S. exchanges with a market cap of $200 million or greater, only 29 passed the screen.

My favorite supplier made the list: MSC Industrial Direct (NYS: MSM) . MSC supports the maintenance, repair, and operations (MRO) market for manufacturers, industrial, and service companies. Along with Fastenal (NAS: FAST) (also on this month's list) and W.W. Grainger (NYS: GWW) (just missed the free cash flow requirement), MSC is a good play on the recovery of the manufacturing sector. All three have beaten the market since it bottomed out in 2009, and I feel MSC has the greatest long-term potential among the three (I own shares).

US Ecology (NAS: ECOL) passed the screen on the same day it reported earnings and lowered guidance. The waste treatment provider lost nearly a quarter of its value yesterday, and is now yielding over 4%. NewMarket (NYS: NEU) , meanwhile, jumped 17% on a strong earnings report last week. Trading at a still-reasonable multiple, fellow Fool Travis Hoium thinks there's still more upside for the specialty chemicals producer.

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 Fool analyst Rex Moore tweets but is not a twerp. He runs a real-money Rising Star portfolio based on his screens. He owns shares of MSC Industrial Direct. Motley Fool newsletter services have recommended buying shares of MSC Industrial Direct. The Motley Fool has a disclosure policy. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.

Copyright © 1995 - 2012 The Motley Fool, LLC. All rights reserved. The Motley Fool has a disclosure policy.