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Here’s the secret behind my best-ever investment on the stock market

Dr James Fox explains why he made what’s now his most successful investment on the stock market. It’s a simple model for investors to try.

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Investing in the stock market can be daunting. Investors often don’t know where to start. However, even without subscriptions to data and analytics companies, they can typically access some fairly thorough earnings and valuation data. These numbers should provide the basis for any share purchase.

Currently, my most successful investment ever is in US software company AppLovin (NASDAQ:APP). The company’s up around 1,500% from my first buy and actually remains one of my daughter’s largest holdings. So, what made it such a great pick?

The value proposition

I bought shares in AppLovin for the first time around two years ago. According to my notes, the stock was trading around 43 times earnings from the previous 12 months but just 14 times earnings for the forward year.

This pointed towards the company’s impressive growth trajectory. Earnings growth was projected at 150% and evidence suggested this wasn’t a one-off or just a good year.

Unsurprisingly, it was about artificial intelligence (AI). The company had just released a new AI model that made app monetisation much more effective — it didn’t open the apps but provided the software for development, advertising and monetisation.

This resulted in a forward earnings per share growth rate that was around 45%. In other words, analysts expected earnings to increase by this much annually over the medium term. The price-to-earnings-to-growth ratio was around 0.5, indicating severely undervalued conditions.

Hold your winners

I’ve not always been the best at holding my winners. I remember selling BAE Systems shares before Russia invaded Ukraine and pocketing a 30% gain. If I’d held, I’d now be up 400%.

But I’ve held AppLovin through multiple earnings cycles and it just keeps smashing analysts expectations. Momentum has been great and analysts were constantly having to revise their expectations upwards — this is always a great sign.

However, there sometimes comes a point when you have to question the valuation. Once again, the numbers are the most important thing. Because investing is about making probability-weighted decisions.

Today, AppLovin trades at 55 times forward earnings but the average medium-term earnings growth rate is 20%. This gives us a PEG ratio of 2.8. That’s nearly six times higher than when I bought the stock.

To me, this suggests, on a probability-weighted basis, that the stock won’t go much higher. I absolutely could be wrong because AI stocks still have a lot of momentum, but the data tells me it’s at or above fair value.

Lessons learned

I don’t expect to hold AppLovin in the family portfolios I manage for much longer. However, I do hope to put this money to good use as I go forward by applying the same model. The stock market might be a little hot, but there’s certainly more companies to buy today with similar growth prospects and better valuations. And for the record, I don’t believe AppLovin is worth considering today.

James Fox has positions in AppLovin. The Motley Fool UK has recommended BAE Systems. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.

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