The perfect stock suggests that it would fit in any portfolio at any time. That perfect stock doesn't exist. Some investors want capital gains from growth only. Others want income. Still others want some of both. So can there be a perfect stock?
There is for each group of investors. For the ones looking for capital gains, the stock would have these attributes:
- Strong revenue growth, achieved by internal growth, not bolt on acquisitions. It's selling more of its products or services, expanding into new markets or introducing new products. Sales are growing faster than its competitors.
- Even stronger earnings growth, meaning that the larger the company gets, the more profitable it becomes, taking advantage of economies of scale. Earnings are growing faster than its competitors.
- Little or no competition, because the company is a first mover in a new market or is heavily protected by patents or geographical monopolies (think large newspapers serving a community). These are attributes Warren Buffett calls "moats". They surround the company, making it very difficult for others to attack its position.
- Entrepreneurial management, the kind that knows growth only comes from a plan, not because they're lucky. A company is either growing or dying. There is no standing still. Once you stand still, you've lost market share and any advantage (technological or others) that you had. Management needs to be committed to growth.
- Costs continue to be a smaller pecentage of sales, meaning managment continually looks for better efficiencies as the company grows.
For income investors, the stock would have these elements:
- A dividend that is above average compared to the industry standard but not so far above that it's unlikely to continue to pay it. Dividends that stray too far from the average for an industry are usually there because investors don't believe the company can afford them. In other words, they're demanding more reward (higher yield) for the risk they're taking.
- A dividend that only takes 50% or less of earnings.
- A strong cash flow so that shareholders know the dividend can be covered even if earnings falter.
- Growing revenues but most likely not in large amounts. Most good dividend paying companies are more mature, having established a strong market position.
- Growing earnings, but again, not ones that jump one year to the next (up or down). The slow but steady approach to growth ensures the dividend will continue to go higher.
- Diversified revenue sources. These can mean the company is in several product categories but it's also necessary that it has many different clients, not reliant on a few for its continued success.
- Solid management. Good management over many years, as measured by Return on Equity and Return on Assets, is essential. If a company has a continuously revolving door at the CEO office, it can't be good. Entrenched management isn't positive either if the results haven't been there. Investors look for long time management with a good track record.
For investors looking for income and growth, pick stocks that have most of the elements described for investors above. The difference will be that most of these stocks won't be as large as the normal dividend stocks or as small as the normal growth stock. They will still be growing but not as fast as a start up. They will pay a dividend but not as large as mature stocks since every dollar spent on dividends is one less dollar that can go toward growth.
Of course there are many other attributes for all three stock types, but these will get most investors started on the right path to find the perfect stock for them.
- Ted Allrich
February 15, 2011