The pretenders have been outed. It’s time for the Holy Grail of Investing to show itself. In past ETR messages, I’ve talked to you about bonds, mutual funds, ETFs, and dividend-paying stocks. They all have their pluses. But in the end, they’ve come up short… sabotaged by a limited upside and (given such a small upside) too much risk. The dilemma facing all investors is how to burst through this low ceiling without encountering excessive risk.

Michael Masterson does it by placing the majority of his money in real estate and private placements, and bonds. That’s one way. But, as he told you yesterday, there’s another way… a much better way… especially if time is as precious to you as it is to me. I’m talking about investing in stocks – which is simply not as time-consuming as the kind of investing that Michael does. And investing in stocks based on a source you can trust takes no time at all. And then if those stocks consistently make big gains…

Well, it’s almost too good to be true. Except, in this case, I’ve actually found a way to save you time and money… and still be able to walk away with big profits. You don’t just stumble upon such a powerful system. There’s a lot of trial and error, frustration, and hard thinking involved – too much of it coming under the rubric of “I’ve been down this road before.” But when it comes together… when the pieces begin to fit… when the ideas behind the system become compelling, you shout, partly in relief and partly in elation, “THIS IS SO OBVIOUS!” (Even though it really wasn’t.)

And when you take the system for a test drive, and it WORKS, you think, “What took so long?” What took so long? The answer to that question is that we’re the first ones to come up with this system… the only ones to our knowledge… and if it were so obvious, every Wall Street company would be using it. But none of them are. We’re the only ones. We think that’s great news for you. But I’m getting ahead of myself… On the Trail of the Missing Link to Huge Profits I looked (and looked) at all the different ways of slicing and dicing the stock market.

I picked the minds of the legendary investors. I learned all about value investing from Benjamin Graham, commodity investing from Jim Rogers, Peter Lynch’s practical advice on how to beat Wall Street, and Warren Buffett’s lessons for corporate America. And I incorporated their teachings into my stock market evaluations… with some success… but not with the consistency I should have been achieving. It was frustrating. Who could I turn to if the investing techniques of the greatest investors could not give me outstanding returns?

There was, however, this one guy… a very wealthy businessman that I know… who buys and sells companies in rapid succession… who doesn’t seem to spend a whole lot of time evaluating these companies. Yet, he seems to make the correct decisions most of the time. I wondered what would happen if I began giving him companies I liked. To find out, I gave him a couple of stock selections. He asked me questions… to which I had lame answers. I gave him a few more.

Again, I was unable to respond to his questions with answers that made much sense. His questions all concerned one thing. He kept asking about the company’s current capabilities. I eventually began to understand that I should look at a company as a sort of living organism… a continuously evolving thing… which static numbers like past annual or quarterly earnings do not come close to capturing.

Under the tutelage of this millionaire businessman, I began to realize that a company’s capabilities are constantly adapting to a changing marketplace… competition… supply and demand… technological innovations… user trends. The list goes on and on… focusing on all the factors that affect a company’s ability to acquire customers and develop more and more products for its customers. From there, it didn’t take a leap to figure out that earnings can go down even as a company is getting a grip on expanding its customer base cheaply and efficiently.

Or… the other way around… that earnings can go up as a company begins to lose its ability to get customers at a reasonable cost. I began applying these ideas to the stock market. Their predictive power surprised even me. All kinds of companies were lighting up my computer screen now… companies I never had paid any attention to. Some were lit up because they were ready to take off. And some were red-flagged, like Hewlett-Packard (HP).

HP was beating Dell like a drum in PC sales and generating pretty good earnings as a result. But I looked deeper and discovered that its customer-acquisition model was getting a little clunky and expensive… by, for example, offering free high-end DVD burners on its low-end consumer desktops. And it mangled its hefty backend operations. You sell a business a server, you should be able to hook in your business-consulting services.

But HP never figured out how to compete effectively with IBM’s “On Demand” service. HP is a good example of a company winning the earnings battle but losing the war for dominance in its industry… just as my new model to evaluate companies would have predicted. HP priced its PCs so low that it killed its gross and operating margins. HP’s operational margins of 3.6% reflect its inability to cut costs. Now, the company is struggling.

The criteria that my wealthy colleague convinced me to use works so well that we call them our “holy grail” criteria… to predict which companies are poised to do well, not fall down. Here are some examples of companies that have done very well, and, not coincidently, aced our criteria BEFORE their stock began to take off. Patina Oil & Gas Corporation Our criteria picked up on its fat margins right away – an unbelievable 81% gross margin and 40% operating margin.

We already knew that customer acquisition for commodities – in this case, oil and gas – is a low-cost operation. The backend is built into the industry: customers coming back for more and more product. From $6 in 2001, the price is more than six times higher now at $40.48. A $10,000 investment four years ago would now be worth $67, 467. Coach Inc. Its telltale signs appeared back in 2000, three years before the stock soared out of sight.

From a hip lineup of handbags, it began extending its products to men and giving both guys and gals lots more stuff… shoes, watches, hats, wallets, electronic accessories, and so on. Plus, its gross margin has averaged 67% over the past five years. From $5.77 in January 2002, the stock price has soared to a current $28. A $10,000 investment three years ago would now be worth $48,527. H&R Block Inc.

Its aggressive growth of backend products into accounting and consulting services for businesses and mortgage and investment services made H&R Block a prime candidate for our criteria… not to mention its impressive 47% gross margin for the past five years. If you had invested in this stock in 2001, when it was going for $20 a share, you would have made a 150% return. It’s now going for $51. A $10,000 investment four years ago would now be worth $25,500. Golden West Financial Corp.

With operating margins of 50%, it generated enough revenues to expand its backend from strictly a savings bank operation to brokerage and investment services. And it took off as a result. Its January 2002 share price of $31 more than doubled in three years to $64.50. A $10,000 investment three years ago would now be worth $20,806. Even during the market downturn of 2000-2002, the above companies grew like crazy.

THE 3 SECRETS OF THE HOLY GRAIL CAN UNLOCK THE DOOR TO HUGE STOCK GAINS

It began to dawn on me… that for the person who knew where to look… how to look… these “holy grail” ideas would comprise the telltale signs of future growth and growth sustainability (which is especially important when the market heads south). That person would be able to zero in on companies with huge growth potential and minimal downside. This is no small feat – and is the fantasy of every stock investor, amateur or professional. What’s more, it wouldn’t matter if the stock market is in the doldrums. It wouldn’t try to predict trends or what the stock market will do. Amazingly, our criteria are rather simple. (Actually, that’s pretty typical for most “revolutionary” ideas.)

SO HERE, FINALLY REVEALED, IS THE “HOLY GRAIL” FORMULA THAT MY COLLEAGUE AND I CAME UP WITH:

Criterion #1: Customer Acquisition Companies need a model of customer acquisition that works in current market conditions. We’re not interested in past performance or in last year’s glowing numbers. If a company can’t figure out a way to grow its customer base within reasonable spending limits… NOW… it’s not going to prosper.

Criterion #2: Backend Revenues The ability to market additional and especially higher-priced products to an existing customer base is the single strongest predictor of a company’s profitability. This is about human nature. Once customers decide to invest their time and money in a given business, they’re psychologically disposed to do it more frequently and in greater depth, because it reinforces the validity of their choice. Companies that have backend products, multiples of quality products, often see profit margins of 15%, 30%, and 50% – and in growth markets or in growth periods, even higher profits of 70% and 100%. This gives these companies a big added advantage.

In addition to these two criteria, we look at one more thing: We award Bonus Points to a company for high margins and low inventory/accounts receivables – two pluses that really help profitability. If a company has high margins, it can spend more money to acquire more customers. That gives it more room for error and more room to grow, even in difficult market conditions. Likewise, companies with low accounts receivables and inventories are much more likely to generate a nice cash flow. And cash flow can help sustain them through difficult times.

PUTTING THE HOLY GRAIL TO THE TEST

Customer acquisition and backend revenue. And big margins as a cushion for when things aren’t going great. Can a formula this straightforward be such a powerful predictor of a company’s success? I had my doubts. (Hey, I’m almost as skeptical as my millionaire colleague!) So these past few months, I’ve tested and retested my formula to make sure it works. We also ran this by a few other investment experts we respect…Porter Stansberry and Steve Sjuggerud. They gave us some valuable advice on fine-tuning the entire system.

I’ve learned a few things: that this combination exists in only a limited number of companies… that hard data on customer acquisition and backend are very hard to get but not impossible (with a little extra work)… and that these companies still need to be subjected to a rigorous evaluation. I’ve also learned that the formula works even better than I expected. It’s churned up several companies that truly look like BIG winners.

See for yourself: The Amusement Park Company Wall Street Hates

There’s an amusement park company whose success – possibly runaway success – depends entirely on making capital investments that it’s already initiated! Average resale value of its parks is around $200 million. The company owns 30 parks. Let’s see, 30 times $200 million equals $6 billion. That’s more than 10 times its cap value of $510 million. This company is priced at a huge discount! About 45% of the company’s revenues derive from its backend business… and I think it will do even better in the future. I expect the company to see returns of 60% to 140% in the next 9-14 months.

The Energy Company

With a Plan for Explosive Growth It has huge gas holdings, plus dribs and drabs in oil, nuclear, and coal. It’s a fully integrated company under smart management. It also grades out very high on all three parts of our “holy grail” formula. It boasts a 52% gross margin and an operating margin of 20%. And as a fully integrated company, it’s able to backend its wholesale delivery of gas and other energy sources into the retail end of electricity supply to households and businesses. This company is making all the right moves. It’s about to break out big-time with annual double-digit growth that could double your investment in 3-4 years.

The 500% Growth Telecom Company

This integrated company provides a full range of telecommunications services to business and residential customers. It also aced all of our “holy grail” criteria. Its gross margin is 50% and its operating margin is 34%. As for backend, it’s expanding its product offering by deploying advanced broadband integrated video, voice, and data services. But here’s the thing. This company’s country isn’t going to let anything… anything… bad happen to it. Not while the government in the middle of privatizing the company and selling off its shares for billions of dollars… as long as it doesn’t screw up. This stock is set for explosive growth – I think triple-figure growth, up to 500% – over the next 1-3 years.

Getting In On One of the Last Pre-Boom Real Estate Markets at a Huge Discount

This Real Estate Investment Trust (REIT) pays its shareholders big fat dividends of 8%-9% yield every year. It has 30 million square feet of high-end office building space in some of the fastest-growing cities in the U.S. The company is in the middle of a brilliant switch in strategy that will allow it to boost earnings by 30%-40%. And it doesn’t depend on increasing occupancy rates… or cutting costs… or getting better prices for buildings. It does depend on cutting back on the front end of buying property that will unleash revenues from the backend of property management and leasing. This company could easily generate 140% returns in the next three years.

WE’RE MAKING THE HOLY GRAIL AVAILABLE TO YOU

I showed Michael Masterson what I had come up with – and we decided that these companies have so much promise… so much upside and so little risk… that we wanted to share them with you. So, beginning next week, we will be featuring a “holy grail” company every month in a brand-new newsletter: The Skeptical Advisor. Why “skeptical”? Because my recommendations must first convince the wealthy colleague I told you about – who has a strong skeptical bent – that my stock selections are the very best place… and the safest place… for him to put his money. (I consider him to be my “Skeptical Advisor.” )

Showing him that a company hits its numbers for the critical areas we’ve identified is just the beginning. I follow that with an exhaustive analysis. I look very hard at the company, its management team, its plans and recent activities, to make sure that everything adds up. Only by offering both… the numbers and a story that goes beyond the numbers in revealing the true current capabilities of a company… can I really be sure that I’ve uncovered an extraordinary investing opportunity. An opportunity so good that my “skeptical investor” would put his own money into it.

Andrew Gordon

Andrew Gordon is a former editorial contributor for Early To Rise Investor’s Edition. He has 20 years of experience working in infrastructure and environmental projects around the world. When he wasn't traveling, he taught marketing and finance courses at the state university of Maryland. Mr. Gordon has authored several books for McGraw Hill and other publishing companies on energy markets, global countertrade practices and the hot growth sectors of China and Russia. He is also a top-rated speaker at financial conferences.

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