7 Steps to Find Winning Stocks

Mark is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Last year I had a problem. I had taken some profit on part of my investment in Apple and needed somewhere to put the gains.

I bought three stocks, and two of them enjoyed significant run-ups. I nearly doubled my investment in one of them within six months. The third has dropped slightly.

Apple had experienced a nice run up over the previous few years (and I had realized a tidy gain), but the company missed earnings targets and announced reduced guidance going forward. Competitors are starting to encroach into the high end of the smartphone and tablet markets where Apple was dominant for many years. Analysts are downgrading the stock.

Knowing when to sell a stock is just as important as knowing when to buy. I wanted to keep the profits I made in the growth portion of my portfolio and try to keep the momentum going, and it looked like a good time to realize at least some gains in Apple. (I still hold some shares. With Apple's recent announcement about increasing its dividend and buying back stock, it appears that my investment will continue to pay off.)

I applied some of what I learned from The Motley Fool staff and fellow bloggers and columnists, from investment books written by people like Peter Lynch (One Up On Wall Street), and from other investors I knew.

Seven steps to find a winner

I generally look for companies with the following characteristics:

1. EPS growth in the range of 15 to 25% per year

2. P/E not too much higher than the growth rate unless the company has a significant competitive advantage (value is part of the process)

3. Not too big (revenues and market cap around $1 or $2 billion - bigger companies are often too unwieldy to grow rapidly)

4. Low debt levels (long-term debt to equity preferably near zero)

5. Strong management in place (with compensation not tied to short term performance - a long term view is best)

6. A business I can understand (Peter Lynch always said "buy what you know")

7. Plenty of free cash flow (cash helps fuel future growth)

I identified a few companies that seemed to meet the criteria and I narrowed the list down to three:

1. Boston Beer (NYSE: SAM)

2. Virtus Investment Partners (NASDAQ: VRTS)

3. Bio-Reference Laboratories (NASDAQ: BRLI)

Boston Beer met all of the criteria. It fit into the size criteria well, with a market cap of about $1.4 billion. It was growing and, at the time, its P/E was in line with its EPS growth rate of about 24% per year. The company had no debt, and the chairman was the guy who started the company, Jim Koch. Boston Beer still uses an old Koch family recipe for its signature product, Sam Adams Boston Lager beer, which I know well.

Virtus Investment Partners also met the criteria, and the numbers looked even better than those of Boston Beer. It was growing at a rate of 70% per year and had a P/E less than 10. It also had almost no debt, the original CEO, George Aylward, was still in charge (the company was a spinoff) and I understood their product (various types of investment instruments). It was also considered one of the best places to work for in the Greater Hartford area, an intangible that's not easily quantified.

The numbers for Bio-Reference Labs also looked good. The company was growing in that sweet spot in the mid-20% range and the P/E was about 20 at the time. It had little debt and the founders of the company were still in charge.

Looking back, however, the only criterion that wasn't quite met was the fact that I really didn't know the company that well, other than what I obtained secondhand from various sources. I did understand the business, medical diagnostic testing, fairly well. I figured it was a growth industry with a rapidly aging population of seniors in the country that would need their services.

So six out of seven criteria seemed to be met.

Results

Since I made these purchases much has happened.

The chart below shows how the stocks have performed. Virtus is up by almost 80%, Boston Beer by nearly 50% and Bio-Reference down slightly by 3%. The average gain was just above 40%, much better than I expected at this stage.

SAM data by YCharts

Virtus filed its 2012 10-k form on March 1 of this year. The company saw revenue gains of 37% and an increase in operating income of 335%. It added several new investment funds to its portfolio during the year and made a major acquisition. It projected continued strong growth for the rest of this year. After reviewing the fundamentals again, I see no reason to sell.

Right after I bought the stock, Boston Beer reported strong earnings and projected further growth into 2013. Highlights from its recent 10-k release included a projection of continued earnings growth in the low-single digits to mid-double digits and gross margin to stay in the mid-50's in 2013. The company also said that, for the first time, Sam Adams Boston Lager will be offered in a can. Although the P/E is now a bit high at 36 after the run-up, Boston Beer still looks like a keeper.

Bio-Reference announced its quarterly results a couple of months ago, beating estimates for EPS, but coming up a bit short on revenue, a trend for many companies right now. However, what really hurt the stock lately was fallout from a wrongful termination suit bought against the company by a former employee. The company's fundamentals haven't changed all that much. I will probably hold onto the stock. I fully expect it to reverse course and go up again.

Conclusion

Looking at a handful of criteria to assess three stocks allowed me to turn large gains I already made on Apple stock into a further 40% increase in the span of less than six months. One of the stocks has nearly doubled in value.

The process can also be used continually to assess whether or not the stocks are still worth holding. For now, it looks like they are.

And if I decide to take some profit off the table from these three down the road, I can use the seven-step method again to identify other potential winners.

Boston Beer's Samuel Adams brand helped to redefine beer and kick off the craft beer revolution in the United States. Success breeds competition, though, and while just a few years ago Boston Beer had claim over most of the craft beer shelf, today the field is crowded. Can Boston Beer rise above the rest, or will it be squeezed between small local breweries on one side and global beer giants on the other? To help you decide, The Fool has compiled a premium research report filled with everything you need to know about Boston Beer's risks and opportunities. Just click here now to find out whether Boston Beer is a buy today.


Mark Morelli owns shares of Boston Beer, Virtus Investment Partners, and Bio-Reference Laboratories. The Motley Fool recommends Apple and Boston Beer. The Motley Fool owns shares of Apple, Bio-Reference Laboratories, and Boston Beer. 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. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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