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Analyst Blog

While the naysayers warn of a crash every time the market hiccups, it is evident that we are currently in one of the most powerful and resilient bull markets we've seen in a long time. Five years of cheap money, pumped-up stock prices and gradually rebuilding investor confidence have powered the market to reach some uncharted territories.

But how long can it last? Amid the melee between the bulls and the bears, a layman investor might get lost. Choosing stocks that promise earnings growth may not be enough to ensure returns if the much-dreaded crash finally hits. And even if one manages to find some stocks that have enough potential to hold ground, investing in most them might not be that lucrative as most of them no longer hold reasonable valuations.

Let’s find some stocks using traditional indicators of stability and growth.

What Drives the Bottom Line?

Sales drive earnings, earnings drive the stock price. This time-honored adage still holds true as an investment idea reviewed in bare essentials.

Since the most recent recession hit six years ago, many companies have slashed costs and restructured operations to become leaner and more efficient. This has translated into improved profit margins, leading to earnings growth despite sedated sales growth.

But earnings advancements based on margin expansion can outpace sales growth for only so long. Over the long term, earnings growth typically trails along the lines of revenue growth.

Companies have been aggressively chasing growth in recent times, as evidenced by the spurt in mergers and acquisitions. Granted, the companies had huge amounts of cash reserves, and the credit markets were practically encouraging them to lever up. But the primary reason remained the relentless pursuit of top-line growth that has become harder and harder to come across in these tricky economic conditions.

Such behavior by the companies only serves to underline the importance of robust revenue growth as a key metric to select stocks.

What Drives Revenues?

Consumer spending is a direct determinant of business sales. With the GDP growing at an impressive rate of 4% in the second quarter, the economy seems to be gaining momentum after shrinking 2.1% in the previous quarter. The unemployment rate is steadily declining. And as hiring picks up, consumer demand will follow suit. Acceleration in wage growth could also boost consumer spending.

In fact, the country trade deficit for June shrank 7%, which could imply a modest upward revision to the already strong second-quarter GDP estimates. Most importantly, it prompts gutsy third-quarter GDP expectations.

As U.S. consumer spending accounts for over two-thirds of the economic output, GDP expansion augurs well for organic growth of the business community.

The Power of Industry Rank

Research indicates that about half the price performance of a stock can be attributed to the industry group that it belongs to. Using a sorting metric called Zacks Industry Rank, one can screen for stocks that belong to the top-performing industries. A top Zacks Industry Rank signifies that more stocks within that group are likely to have upward earnings estimate revisions, implying bullish outlook for the industry.

Historically too, we have found that the top 50% of Zacks-Ranked Industries outperform the bottom 50% by a factor of more than 2 to 1. So it’s a good idea to leverage the Zacks Industry Rank to shortlist stocks.

Growth & Valuation Metrics

Apart from a strong track record of sales growth and a robust industry rank, one should look for companies with strong long–term growth expectations. This should help select companies with strong earnings potential driven by revenue growth.

We have shortlisted three stocks based on the above metrics and incorporating valuation multiples. All these stocks are trading at a discount to their respective peer group average forward P/E and P/S ratios.

Lithia Motors Inc.

Lithia Motors is a leading automobile retailer and automotive franchisee in the U.S., serving both urban and rural markets. With the auto market continuing to enjoy robust momentum, Lithia Motors is displaying healthy growth across its segments.

The auto dealer has been on an acquisition spree lately, acquiring/opening eight stores so far this year. The acquisitions of Vic Alfonso Cadillac, Braley & Graham Buick GMC and Access Ford Lincoln are expected to add $165 million annually to its revenues. The company is also set to acquire DCH Auto Group Inc., which will augment revenues by $2.3 billion approximately per annum.

The Retail/Wholesale Auto/Truck industry currently holds a Zacks Industry Rank of 34 out of 265 industries, placing it in the top 15% bracket.

Sales Growth in Previous Year = 20.8%
Long-Term Growth Consensus Estimate = 25%
P/E Ratio: 18.1; Peer Group P/E Ratio: 24.2
P/S Ratio: 0.5; Peer Group P/S Ratio: 1.0
Zacks Rank #1 (Strong Buy)

Constellation Brands Inc.

Constellation Brands is a leading international producer and marketer of beverage alcohol brands, boasting a formidable portfolio of popular labels across the wine, spirits and imported beer categories. The company is the largest multi-category alcohol supplier in the U.S. and the largest wine company in the world.

The company’s top-line has benefited from the consolidation of the Crown Import business as well as robust demand for beer. Last year, the company acquired Grupo Modelo's U.S. beer business for a sum of $4.75 billion, boosting its sales by $2 billion in fiscal 2014.

Constellation's beer segment now represents about half of its total sales; and it grew a strong 10% last year, on the back of new product offerings, new points of distribution and effective marketing and advertising strategies.

The Alcoholic Beverages industry currently holds a Zacks Industry Rank of 34 out of 265 industries, placing it in the top 13% bracket.

Sales Growth in Previous Year = 72.6%
Long-Term Growth Consensus Estimate = 17.3%
P/E Ratio: 19.9; Peer Group P/E Ratio: 20.3
P/S Ratio: 3.0; Peer Group P/S Ratio: 13.7
Zacks Rank #2 (Buy)

Barrett Business Services Inc.

Barrett Business Services, an outsourcing firm, provides business management solutions, combining human resource outsourcing and professional management consulting. With the company’s brand gaining more recognition, its client penetration is reaching deeper, ranging from industries such as telecommunications and transportation & shipping to manufacturing and food processing.

The company’s commendable sales growth in recent times was attributable to organic growth arising from existing client base as well as strong referral channels. Also, the company’s client retention rate of over 90% indicates sustained revenue growth acceleration, going forward.

The outsourcing industry currently holds a Zacks Industry Rank of 96 out of 265 industries, placing it in the top 36% bracket.

Sales Growth in Previous Year = 32.3%
Long-Term Growth Consensus Estimate = 22.5%
P/E Ratio: 18.8; Peer Group P/E Ratio: 20.1
P/S Ratio: 0.7; Peer Group P/S Ratio: 2.8
Zacks Rank #1

Bottom Line

The crux remains that the top-line drives the bottom-line. A trend of bottom-line growth consistently outpacing top-line growth in most quarters has been a matter of concern throughout the recovery. Companies have jacked up earnings for years by slashing costs. However, going forward, it is clear that only companies with strong revenue growth prospects can retain their earnings momentum and augment shareholder wealth.

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