The Simple Way I Search for the Next Hit Stock

By Markets Fool.com

Where in the world is the next hit stock? Image source: The Motley Fool.

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With the broader stock market suffering a steep pullback so far in 2016, now is a great time for long-term investors to put their hard-earned money to work. But how can you identify the very best stocks with the greatest potential for generating market-beating returns?

It doesn't have to be difficult. We asked three Motley Fool contributors how they find the next hit stocks, and their approaches are surprisingly simple. Read on to see what they said.

Steve Symington: It might seem counterintuitive, but I've realized all too often that "the next hit stock" is one I've already found. Put another way, winners tend to keep on winning. And adding to your biggest winners is a great way to generate market-beating returns over the long run.

Take Under Armour , for example, which I first gave a thumbs-up in my CAPS portfolio at a split-adjusted $7.38 per share in early 2010. Shares have climbed more than 930% since then as of this writing, absolutely crushing the S&P 500's 64% gain over the same period.

But my original thesis really hasn't changed, and I've added to my initial position several times since I first bought six years ago. In fact, speaking at Under Armour's 2015 Investor Day in September -- when the company revealed ambitious plans to nearly double annual revenue to $7.5 billion by 2018 -- CEO Kevin Plank noted that apart from its recently increased presence in the connected fitness space, Under Armour's five core growth drivers remain the same as the ones it laid out in its road show a full decade earlier. Namely, these include growing revenue from men's apparel, women's apparel, footwear, international, and direct to consumer.

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As such, I pounded the table for Under Armour in December despite a loud chorus of skeptics who continued to insist that shares looked overvalued, only to watch Under Armour stock skyrocket 18% in a single day after it turned in yet another stellar quarterly performance. That's not to say we should completely ignore valuation. But considering Under Armour's $16 billion market capitalization is still nearly six times smaller than that of Nike -- which itself reported healthy 12% currency-neutral growth last quarter -- and knowing international revenue only comprised around 12% of Under Armour's total sales last quarter, I think Under Armour is just one of many "hit stocks" most investors don't realize is sitting right under their noses.

Todd Campbell: Unsure if you're going about finding winning investments the right way? You're not alone. There are thousands of stocks to choose from and the markets are notoriously fickle, so finding the next big winner isn't nearly as simple as it sounds.

I've discovered that having a plan is better than winging it, so I begin my research by asking three questions:

  • Is the company a leader in its field?
  • Will products/services in the works allow it to remain a leader?
  • Is the company on solid financial ground?

Let's take Gilead Sciences as an example. Gilead Sciences dominates the market for HIV and hepatitis C drugs, and its sales have tripled to $32 billion over the past few years. Is it a leader in its field? You bet. The company has a slate of new HIV therapies that include TAF, a safer reformulation of Viread, coming to the market soon, and it expects an FDA decision on its next-generation hepatitis C drug this summer. Will products help it remain a leader? I think so. Finally, the company's balance sheet has $26 billion in cash, up from $11.7 billion a year ago, so the finances look ship-shape, too.

Although investors will always need to dig deeper to understand each individual company's up- and down-sides, answering these three questions off the bat is a great way to start separating winners from losers.

Andres Cardenal:When looking for "the next hit stock" I typically focus on businesses with strong potential for growth and solid competitive advantages allowing the company to capitalize on those growth opportunities. The network effect is a key source of competitive strength in the online world, so I am particularly attracted to online companies benefiting from this powerful driver.

In simple terms, the network effect means that the service becomes more valuable as it gains size over time. It's quite common in industries such as e-commerce or social media. A bigger platform means a more valuable one, and users attract each other to the strongest platforms. This creates a self-sustaining virtuous cycle of growing size and increased value for users.

eBay is a textbook example of a company benefiting from the network effect. Buyers want to go to the e-commerce platform where they can find lots of sellers and more convenient prices, while sellers need to find as many potential buyers as possible. This means that buyers and sellers attract each other to eBay, and a bigger platform means a more valuable service for users on both sides of a transaction.

Based on data for the fourth quarter of 2015 eBay has an active buyer base of 162 million accounts, a 5% year-over-year increase. Total gross merchandise value was $21.9 billion during the quarter, so eBay is clearly past the inflection point in terms of achieving critical scale when it comes to both the size of the network and overall commercial activity going on in the platform.

This critical size means that eBay is providing lots of opportunities for buyers and sellers to find someone to make a deal with, and a bigger eBay means a more valuable one. This is clearly a top source of competitive strength and a crucial growth driver for eBay and other companies that know how to capitalize on the power of the network effect.

The article The Simple Way I Search for the Next Hit Stock originally appeared on Fool.com.

Andrs Cardenal owns shares of Gilead Sciences. Steve Symington owns shares of Under Armour. Todd Campbell owns shares of Gilead Sciences. The Motley Fool owns shares of and recommends eBay, Gilead Sciences, Nike, and Under Armour. 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.