2003 ended on a high note with the S&P 500 rallying in December to finish up over 28%, the first positive year since 1999. It was a well appreciated recovery marking the end to the worst bear market since the Great Depression.

Time to look ahead… In the process of developing an investment strategy for each New Year I always ponder the question – What will be the driving forces for the market? More often than not there are multiple factors to consider. However, the primary catalyst for the stock market in 2004 might just be one very important variable. In my view, earnings growth will be the driving force for the stock market in 2004. While that may sound simplistic it is anything but.

To begin with, earnings growth must be analyzed relative to historical data and current expectations. Let’s explore this using an example. Company A grows earnings at 10% compared to a historical average of 6%, while Company B grows earnings at 20%, but below its long term average of 30%. On the surface it might appear that A would out perform B. However, the probability of one out performing the other will be affected not just by the historical data, but also by expectations. Company B may in fact out perform Company A, despite lagging its historical averages, if earnings exceed consensus expectations by a wide enough margin. While this may seem logical, earnings expectations change continually making them difficult to quantify.

Following this argument, the formula for stock picking success is to discover companies that can out pace both their historical records and the trend in expectations. In my experience, there are two steps to finding this Holy Grail. First, it is critical to identify the key success factors for a company. Some of these factors may include cost control, new product momentum, changes in market share, the ability to harness technology, and cash flow generation.

The second step involves estimating the upside and downside potential related to these key success factors. Again, let’s look at an example. Drug Company A introduces a new product sooner than expected and sales exceed forecasts. How much upside potential is there in the stock? This depends on several factors including the sustainability of the sales momentum and the subsequent actions by competitors. In the opposite case, Drug Company B announces a delay in a new product introduction thereby leading to lower sales and earnings forecasts. The downside potential is dependent on the same type of issues. In my view, an attractive stock should have an upside to downside ratio of at least 2 to 1.

Admittedly, there are other issues that may affect the market in 2004. While there is always the potential for an exogenous shock, most of the issues we face today are well known, which means the market has already discounted most of their impact. For instance, the U.S. economy is definitely gaining strength, but this is not new news. Also, the global battle against terrorism is a fact of life, and although none of us like the hassle and expense of additional security procedures, we have learned to adapt. Lest we forget, it’s an election year. Over the next several months we will be bombarded by political rhetoric, most of which will be ignored by the market, thankfully.

So I’ll stick with earnings growth as the driving force for portfolio performance in 2004. Whatever develops I hope to provide meaningful commentary on these and other issues as the year unfolds. In the meantime, may the New Year be an enriching one for you in all respects.