Stock Picking – Consistent Earnings Growth

As said in previous posts, finding stocks that will do well over the next day or week is difficult.  Even finding stocks that will do well over the next month or so is difficult.  The reason is that any news that will affect the stock price in the near term is already priced into the shares.  Whether the stock will go up or down is really a matter of luck since the short-term behavior of the stock will be somewhat random (although our minds will always try to find patterns, even if none exist).

In the long-term, however, prices can be predicted (at least the odds can be placed largely in our favor) for stocks that have predictable growth patterns.  Companies that have increased earnings at a sustainable and relatively reliable rate can generally be expected to continue to do so unless something dramatically changes about the way they do business or they run out of room to grow.  Note the important caveats that the growth rate must be reliable and sustainable.  It must be reliable in that earnings grow consistently rather than cycle between really good and really bad.  The rate must be sustainable because extremely large growth rates (say 40% per year) cannot continue more than a few years.  Because stock price growth tends to follow earnings growth — e.g. if a stocks earnings are increasing at 10% per year the average stock price will tend to increase at about 10% per year — if stocks can be found that have consistent earnings growth, it can be expected that the price of these stocks will increase at the same rate.

So why is it that there will be no price differential for events that happen in the near-term, such as earnings surprises, but there will be in the long-term?  It is not because everyone does not have access to the earnings predictions — they are widely available.  It is not that others can’t pick out stocks that have consistent earnings growth — they can, and stocks that have this property tend to command a premium and have P/E ratios that are higher than their peers.  The reason has to do with how stocks are priced relative to other investments, which is based primarily on the projected rate of return and the risk involved.  I’ll cover both aspects in future posts.

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Disclaimer: This blog is not meant to give financial planning advice, it gives information on a specific investment strategy and picking stocks. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing

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