By: DanielXX

As a fundamentals-based investor, I am always looking to find bargain buys on the basis of value and I often try to spot trends (see my blog Trendspotting) which could lead to a re-rating of particular stocks. Once one has identified a particular trend, he can find companies which have particular leverage to that trend. A useful framework for finding good companies is identifying a divergence in its revenue-costs spread, which is of course an elaborate way of describing the income.

The spread is simply the numerical difference between A and B (ie. A-B). The spread will widen/diverge if (1) A goes up while B remains the same; (2) A remains while B decreases; (3) A rises more than B or declines less than B. The most divergence is of course when A rises while B drops. A concept that is easily applied to the earnings framework for companies.

The key benefit for thinking about earnings as a spread between revenue and costs is that it compels the investor/trader to think about the components of income individually insofar as they contribute to the spread (which is also the profit margin). Often, the fundamental factors driving revenue are independent of that driving costs. Identifying stocks where certain trends favour revenue growth while other particular trends point to cost decrease ie. a form of spread divergence, could suggest a stock with potentially explosive profit margin growth.

How To Make Money In Stocks Series
How To Make Money In Stocks Part 1: Back to the Basics
How To Make Money In Stocks Part 2: The Time Horizon Premium
How To Make Money In Stocks Part 3: The Illiquidity Premium
How To Make Money In Stocks Part 4: Keeping It Simple
How To Make Money In Stocks Part 5: Learning to sell