The Anatomy of Stocks That Go Up

Stocks That Go Up (STGU)

What Makes Stocks Go Up?

It’s such a simple question, but invites so many complicated answers.

If you’re an investment banker, it’s M&A activity. If you’re a value investor, it’s earnings potential. If you work at a pod shop, it’s quarterly earnings beats.

Some years ago I found myself facing this very question, posed to me somewhat angrily by my portfolio manager.

Do you know what makes stocks go up?

Given there are so many opinions about what make stocks go up, I sought to answer the question in a rational way, with data. (Aside: He was looking for me to say it was quarterly earnings beats.)

I collected what felt like every quantifiable metric - stock price performance, revenue growth, margins, debt levels, quarterly performance vs expectations, etc - about every public company going back 30 years and put it into a database and ran the biggest regression I’ve ever run.

From a very complicated process came a simple answer. Only two metrics mattered across all time frames. They were:

  • Revenue growth

  • Earnings growth

A simple question gets a simple answer. (Narrator voice: The answer was not quarterly earnings beats.)

So much for the investing books that say the best way to make money in the market is to buy stocks with “margins of safety” and ones that fit the context of some “magic formula” of the stock market!

Turns out the magic formula doesn’t work so well if there isn’t a revenue tailwind and cheap stocks get cheaper as their revenue fails to thrive.

The Importance of Growth for Superior Shareholder Return

I’m certainly not the only person to have discovered this - BCG included it in one of their reports entitled “The Importance of Value-Creating Growth.”

Source: The Importance of Value-Creating Growth - BCG Analysis. Repurposed by Dubra.

I had independently stumbled into the same conclusion reached by BCG that revenue growth dictates the vast majority of share price performance. It’s an intuitive conclusion after all - You sell more stuff and your stock goes up!

Not one to blindly embrace a simple answer and thinking surely there was more to uncover, I decided to dig a bit deeper. I then posed the following question to myself:

What types of companies produce top tier returns over long periods of time?

I asked this question hoping to determine what a STGU looks like. It is one thing to look back at a steep upward sloping stock chart and point out the obvious “Hey, that’s a stock that goes up!” It is another to identify a STGU early and hold.

At this point I had determined that revenue growth, or even the prospect of revenue growth, is a pre-requisite. There had to be more determining characteristics I could identify.

Digging Deeper Into The Mystery of STGU

I went back to my massive data set of financial information and trimmed it down to the 300 best performing stocks of the last 5, 10, 20 and 30 years - The STGU of yesteryear. I then grouped these 300 stocks using Principal Components Analysis into like-groupings.

I found 5 distinct STGU groups… 5 different types of STGU, if you will. Those groups are listed here:

  • Group 1: The Early Stage Innovators – Exceptionally high revenue growth companies that generally run at lower margin. These companies are growing at all costs.

  • Group 2: Maturing Innovators – Very high margin businesses that grow somewhat slower than The Early Stage Innovators.

  • Group 3: Mature High Moat – Moderate revenue growth and strong margins. Far higher margins than The Early Stage Innovators but lower margin than the Maturing Innovators.

  • Group 4: Defensible and Predictable – Stocks with relatively low revenue growth and margins, but have strong moats and competitive advantages (regulated oligopolies, etc).

  • Group 5: The Survivors – This is a group that is otherwise unremarkable in terms of revenue growth and margins whose returns are predominantly the result of surviving major periods of uncertainty in the markets.

These groupings are telling, in a way. They describe succinctly the circle of life of Corporate America. Some call this the S-curve of business.

In their beginnings companies innovate, test product-market fit and grow at all costs (Group 1). Then they begin to mature, focus on unit economics and scale operations (Group 2). Next, their growth is moderated as market opportunity is saturated and they begin to focus on profitability (Group 3). Finally, they establish moats and persist (Group 4).

So What Does This Mean?

It actually means nothing other than to demonstrate to us the maturation process of a company that will one day become a member of the Defensible and Predictable group. This analysis simply shows that revenue growth over long periods of time leads to top tier returns in the market (duh, even BCG figured that out!).

There is a problem here. The problem is we can’t know early in a company’s life if that company is a STGU.

What we need to do now is to identify what a STGU does NOT look like. This will help us avoid mischaracterizing a stock early in its life.

Therefore, I pose a new question:

Do you know what makes stocks go down?

Stocks That Go Down (STGD)

In an attempt to answer this question, I did the same statistical process as above with the bottom 300 companies by total shareholder return (the ones that were still listed in the market at least).

Similarly, I grouped them into like-groupings to characterize different types of STGD. Those groups are listed here (and they are much more interesting than the STGU):

  • Group 1: Indefensible – Declining revenue and declining margins (i.e. stocks with weak moats and no competitive advantages).

  • Group 2: Closed-Ended Growth Opportunities & Customer Concentration – Firms that sell into markets that are by nature closed-ended. These firms are subject to the demands of large customers.

  • Group 3: The Disrupted – Firms that have seen technology disrupt their legacy businesses and subsequently revenue and margins fall.

  • Group 4: High Debt – Firms that succumb to the weight of immense financial leverage. Small mistakes are amplified and result in massive stock underperformance.

  • Group 5: High Operating Leverage & Cyclical – Cyclical businesses that see their profitability disappear as the business cycle begins to decelerate.

People rarely spend the time to think about what makes a bad business. It is just not a thought that crosses many people’s minds. But when you step back and think about it there are far more businesses dead and gone than are operating today. They all went away for some reason.

Enron is gone because of leverage and fraud. Blockbuster is gone because of operational leverage and disruption. Many oil companies are gone because the cycle burst. Occasionally the Fed lets banks fail too… in their case because of financial leverage.

What we find is that STGD generally suffer from combinations of financial leverage (too much debt), operational leverage (too much overhead) and cyclicality (not enough revenue when they need it). These characteristics amplify negative developments and create scenarios of irrecoverable loss for investors.

STGD also sometimes suffer from closed-ended growth opportunities. It is often hard for a company to show revenue growth when they are captive to the decisions of a major customer or operate in a niche that is already fully exploited.

When selecting STGU, we should do our best to avoid these characteristics of STGD in an effort to avoid irrecoverable loss.

Putting It Together

As we have deduced, STGU generally coincide with high revenue growth and the ability to grow at high rates over long periods of time. Better said, STGU tend to benefit from open-ended growth opportunity that enables both high growth and high durability of that growth. (Jeff Bezos will tell you this second point is extremely important.)

Stocks that go down or otherwise experience irrecoverable loss generally exhibit characteristics of financial leverage, operational leverage and cyclicality. Those things are to be avoided in a thoughtful way.

What This Blog Is Meant To Be

This blog is meant to be a journey of identifying stocks that look like stocks that go up.

I’ll post 1 stock profile per month interspersed with general commentary and other musings. Thank you for reading this far and I look forward to writing more in the future!

-Dubra

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