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Annual Earnings Increases

The second characteristic that William O'Neil found in common in the top growth stocks he studied over a forty year period was consistent annual earnings increases over the previous five years. He even puts it in bold face - "Each year's annual earnings per share for the last five years should show an increase over the prior year's earnings."

O'Neil found that the average annual earnings growth rate for the top performing stocks was 24% a year. In fact, three out of four stocks studied showed a positive annual earnings growth rate. The other one out of four were turnarounds.

He emphasizes consistent growth. A track record of earnings per shares of $3, $5, $7, $2 and $3 is not good enough. Though you can tolerate one bad year, says O'Neil, the subsequent year must surpass the previous high, not just the bad year. But the more stable and consistent the growth rate the better.

One pitfall to avoid is that some stocks that are labelled growth stocks by the popular press are, in fact, mature or as O'Neil puts it, "nearly senile" growth stocks. Their growth rate looks attractive, but if you look at the stock more closely, you'll find that it is not growing as fast as it did in its prime.

Another pitfall to avoid is stocks whose annual growth record looks good but whose current earnings in the last two quarters have slowed significantly. Both Annual and Current Quarterly Earnings must be excellent. Such a happy confluence greatly increases your prospects of a successful investment.

The Price/Earnings Ratio

Many analysts make a great deal out of the price to earnings ratio or P/E. But in fact, O'Neil points out that the average P/E for the top performing stocks in their early emerging stage between 1953 and 1985 was 20 compared to 15 for the Dow Industrials. While they were advancing, the P/E for these stocks increased to 45. In other words, investors who shied away from higher P/E ratios during those years missed out on the best investments.

Two anecdotes he relates point out the folly of relying on P/E ratios. He tells of a burly and aggressive investor bursting into his friend's brokerage office in June 1962 bellowing that Xerox was overpriced with a P/E of 50. He sold 2000 shares short at $88. This "obviously overpriced stock" then proceeded to a split adjusted equivalent of $1300!

The other story is about a mistake O'Neil himself made. As a neophyte investor he bought Northrop because he thought it was cheap with a P/E ratio of 4. He watched in stunned disbelief as the stock declined to a P/E of 2.

Is Today's Market Different?

In this modern era of fast growing dot-coms without any earnings at all, we should consider carefully O'Neil's advice. Today there is a great emphasis on growing revenues, but little on earnings. But some day, the chickens will come home to roost. Some day these companies must start showing profits. And not just profits but accelerating profits if they are to hang on to their valuations.

But why buy the stock of a company before it starts showing a profit when in many cases you can buy undervalued stocks that are already showing strong and profitable growth? In the case of the dot-coms, if a company's losses per share are decelerating as its revenues grow, then clearly it is on the path to eventual profitability. But beware of companies whose losses are accelerating in spite of increasing revenues.

Fortunately there are some resources for searching out stocks with strong growth on the Internet.

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