C = Current Quarterly Earnings Per Share: How Much Is Enough?

M/A-Com Inc.
Humana Inc.
Kirby Exploration Co.

What did shares of the above-mentioned microwave component man-
ufacturer, hospital operator, and oil Service Company have in common?
From 1977 to 1981, they all posted price run-ups surpassing 900%.
In scrutinizing these and other past stock market superstars, I've
found a number of other similarities as well.

For example, tradiiig volume in these sensational winners swelled
substantially before their giant price moves began. The winning Stocks
also tended to shuffle around in price consolidation periods for a few
months before they broke out and soared. But one key variable stood
out from all the rest in importance: the profits of nearly every outstand-
ing stock were booming.

The common Stocks you select for purchase should show a major per-
centage increase in the current quarterly earnings per share (the most
recently reported quarter) when compared to the prior year's same
quarter.

Earnings per share are calculated by dividing a company's total after-
tax profits by the company's number of common shares outstanding.
The percentage increase in earnings per share is the single most impor-
tant element in stock selection today.

The greater the percentage of increase, the better, as long as you
aren't misled by comparing current earnings to nearly nonexistent
earnings for the year earlier quarter, like 1 cent a share.

Ten cents per share versus one cent may be a 900% increase, but it is
definitely distorted and not as meaningful as $1 versus $.50. The 100%
increase of $1 versus $.50 is not overstated by comparison to an unusu-
ally low number in the year ago quarter.

I am continually amazed at how many professional pension fund
managers, as well as individual investors, buy common stocks with the
current reported quarter's earnings flat (no change), or even worse,
down. There is absolutely no reason for a stock to go anywhere if the
current earnings are poor.

Even if the present quarter's earnings are up 5% to 10%, that is sim-
ply not enough of an improvement to fuel any significant upward price
movement in a stock. It is also easier for a corporation currently show-
ing a mere increase of 7% or 8% to suddenly report lower earnings the
next quarter.

Seek Stocks Showing Big
Current Earnings Incrcascs

In our models of the 500 best performing Stocks in the 40 years from
1953 through 1993, three out of four of these securities showed earn-
ings iricreases averaging rnore than 70% in the latest publicly reported
quarter before the Stocks began their major price advance. The one out
of four that didn't show solid current quarter increases did so in the
very next quarter, and those increases averaged 90%!

If the best Stocks had profit increases of this magnitude before they
advanced rapidly in price, why should you settle for mediocre or down
earnings?

Our study showed that among all big gainers between 1970 and 1982,
86% reported higher earnings in their most recently published quarter,
and 76% were up over 10%. The median earnings increase was 34%
and the rnean (average) was up 90%.

You may find that only about 2% of all Stocks listed for trading on the
New York or American stock exchanges will, at any one time, show
increases of this proportion in current quarterly net iiicome.
But, remember you want to find the exceptional Stocks rather than
the lackluster ones, so set your sights high and Start looking for the
superior Stocks, the small number of real leaders. They are there.
Success is built on dreanis and ideas; however, it helps to know exact-
ly what you're looking for. Before you Start your search for tomorrow's
super stock market leader, let nie teil you about a few of the traps and
pit falls.

Watch Out for Misleading
Reports of Earnings

Have you ever read a corporation's quarterly earnings report that stated,
"We had a terrible first three months. Prospects for our Company are turn-
ing down due to inefficiencies in the home office. Our competition just
came out with a better product, which will adversely affect our sales.
Furthermore, we are losing our shirt on the new midwestern Operation,
which was a real blunder on management's part."

No! Here's what you see. "Greatshakes Corporation reports record sales
of $7.2 million versus $6 million (+ 20%) for the quarter ended March
31." If you own their stock, this is wonderful news. You certainly are not
going to be disappointed. You think this is a fine Company (otherwise you
wouldn't own its stock), and the report confirms your thinking.
Is this record-breaking sales armouncement a good report? Let's sup-
pose the Company also had record earnings of $2.10 per share of stock for
the quarter. Is it even better now?

What if the $2.10 was versus $2 (+ 5%) per share in the same quarter
the previous year? Why were sales up 20% and earnings ahead only 5%?
Something might be wrong¡Xrnaybe the company's profit margins are
crumbling. At any rate, if you own the stock, you should be concerned and
evaluate the Situation closely to see why the earnings increased only 5%.
Most investors are impressed with what they read, and companies love
to put their best foot forward. Even though this corporation may have had
all-time record sales, up 20%, it didn't mean much. You must be able to
see through slanted published presentations if you want the vital facts.
The key factor for the winning investor must always be how much the
current quarter's earnings are up in percentage terms from the same quar-
ter the year before!

Let's say your Company discloses that sales climbed 10% and net income
advanced 12%. This sounds good, but you shouldn't be concerned with
the company's total net income. You don't own the whole organization.
You own shares of stock in the corporation. Perhaps the Company issued
additional shares or there was other dilution of the common stock. Just
because sales and total net income for the Company were up, the report
still may not be favorable. Maybe earnings per share of common stock
inched up only 2% or 3%.

The Debate on Overemphasis
of Current Earnings

Recently it has been noted that Japanese firms concentrate more on
longer-term profits rather than on trying to maximize current earnings
per share.

This is a sound concept and one the better-managed organizations in
the United States (a minority of companies) also follow. That is how
well-managed entities create colossal quarterly earnings increases, by
spending several years on research, developing superior new products,
and cutting costs.

But don't be confused. You as an individual Investor can afford to wait
until the point in time when a Company positively proves to you its
efforts have been successful and are starting to actually show real earn-
insrs increases.

Requiring that current quarterly earnings be up a hefty amount is just
another smart way the intelligent Investor can reduce the risk of exces-
sive mistakes in stock selection.

Many corporations have mediocre management that continually pro-
duces second-rate earnings results. I call them the "entrenched main-
tainers." These are the companies you want to avoid until someone has
the courage to change top management. Ironically, these are generally
the companies that strain to pump up their current earnings a dull 8%
or 10%. True growth companies with outstanding new products do not
have to maximize current results.

Look for Accelerating
Quarterly Earnings Growth

My studies of thousands of the most successful concerns in America
proved that virtually every corporate stock with an outstanding upward
price move showed accelerated quarterly earnings increases some time
in the previous ten quarters before the towering price advance began.
Therefore, what is crucial is not just that earnings are up or that a
certain price-to-earnings ratio (a stock's price divided by its last twelve
months' earnings per share) exists; it is the change and improvement
from the stock's prior percentage rate of earning increases that causes a
supreme price surge. Wall Street now calls these earnings surprises.
I once mentioned this concept of earnings acceleration to Peter
Vermilye, the former head of Citicorp's Trust Investment Division in
New York City. He liked the term and feit it was much more accurate
and relevant than the phrase "earnings momentum" sometimes used by
Investment professionals.

If a Company's earnings are up 15% a year and suddenly begin spurt-
ing 40% to 50% a year, it usually creates the basic conditions for impor-
tant stock price improvement.

Check Other Key Stocks in
the Group

For added safety, it is wise to check the industry group of your stock.
You should be able to find at least one other noteworthy stock in the
industry also showing good current earnings. This acts as a confirming
factor. If you cannot find any other impressive stock in the group dis-
playing strong earnings, the chances are greater that you have selected
the wrong investment.

Note the date when a company expects to report its next quarterly
earnings. One to four weeks prior to the report's release, a stock fre-
quently displays unusual price strength or weakness, or simply "hesitates"
while the market and other equities in the same group advance. This
could give you an early clue of an approaching good or bad report. You
may also want to be aware and suspicious of stocks that have gone several
weeks beyond estimated reporting time without the release of an earn-
ings announcement.

One last point to clarify: You should always compare a stock's per-
centage increase in earnings for the quarter ended December, to the
December quarter a year earlier. Never compare the December quarter
to the immediately prior September quarter.

You now have the first critical rule for improving your stock selection:
Current quarterly earnings per share should be up a major percentage
(at least 20% to 50% or more) over the same quarter last year. The best ones
might show earnings up 100% to 500%! A mediocre 8% or 10% isn't
enough! In picking winning stocks, it's the bottom line that counts.

-Excerpt from William O'Neal's How To Make Money in Stocks.