What Would Aristotle Buy?

We're all searching for winning stocks. The hard part is finding them.

Some people buy stocks that are on a roll, thinking their hot streak will last. Others buy stocks that are out of favor, expecting they'll come back. Many rely on "tips" from friends, pundits, you name it. But how many investors truly have a method (you could also call it a philosophy) of investing in which they have confidence? One that promises to deliver above-average returns over the long haul?

All the great investors approached the market with a particular point of view that was bedrock for how they selected stocks. And while we can learn much from these top investors, we can also take from the greatest thinkers in human history to guide us in our investing. Today we consider how Aristotle (whom many consider the most knowledgeable person of all time) might have approached the stock market.

Reality is everything
Aristotle was a pupil of Plato, who in turn studied directly under Socrates (read about what Socrates would buy, as well as Machiavelli). These three guys were a pretty potent triple threat for the Greek team during the third and fourth centuries B.C. But Aristotle blazed a different path from his mentor. Plato believed the world we perceive with our senses is constantly changing, and argued there's a more permanent form of reality only accessible to the intellect.

Aristotle thought this was nonsense. Reality is all there is, and our chief goal should be to understand the world we inhabit as completely as possible. His passion and energy for discovering how things really work was incredible. Aristotle was the first to systematically explore such basic fields as physics, economics, psychology, meteorology, and political science. What's more, he invented logic as we think of it today -- what makes an inference valid, or not. For over two thousand years, the study of logic meant the study of Aristotle's logic.

That's a house?
One of Aristotle's insights is that a "thing" is not what it's made of; it is rather the purpose it serves. He uses the example of a house. If a builder you hired just dropped a load of bricks, tile, and wood on the site and said he was finished, you would probably object. All you've got is a big pile of stuff, not a house. It only becomes a house when the materials are put together in a particular way. And your house could just as easily be constructed of different materials ... say, stone and glass.

What would Aristotle buy?
I could go on and on with Aristotle's insights into the real world, but that's not what we're here for. So let's get to the point. What would Aristotle believe makes a stock a truly great investment, rather than the flavor of the month, or a tip that went bad?

Because Aristotle was a highly logical thinker, I expect he would devise a set of rules for selecting companies that digs below the surface, to get at the real fundamentals. He would ignore analyst forecasts for future results, judging them as unproven, and just someone else's opinion, which is probably not reliable.

His company selection criteria might look something like:

1. A company that makes or performs something of real value, now and for the foreseeable future.

2. A business that generates higher than average profit margins, demonstrating superior management and a quality customer value proposition.

3. A superior track record of earnings growth and total investor return.

4. Current valuation that appears attractive, or at least reasonable.

Armed with these rules, he would be astonished at the research tools available to him in the modern world. In no time at all, he might sort out the following companies in the service sector:

He might then proceed to product manufacturers, and identify:

Each of these companies has generated double-digit compound EPS growth and total shareholder returns over the 10-year horizon. They have operating margins higher than their industries' averages. They are industry leaders, and not a single company on this list trades at a trailing-12-month price earnings ratio higher than 19.

Not all, or any, of the companies on this list may be to your liking. Admittedly, all of these companies are large-cap stocks. Your taste may run toward small caps or cutting-edge technology providers.

What's your investment philosophy?
The point is, unless you're very lucky, or satisfied with index funds, you must have an investment philosophy you believe will work. Only then can you expect to achieve above-average returns over a sustained period of time. (For the average investor, by the way, index funds aren't a bad idea).

Aristotle would suggest that you ground your investment philosophy in things that can be observed -- he would say, "how things really are." He would then insist you perform diligent research, and only make up your mind after careful consideration. Sage advice from a master.

Not everyone has this kind of time to devote to stocks. If your days are as hectic as mine, you might consider jumpstarting your research with the Motley Fool Inside Value service. Let a team of experts cull through hundreds of stocks for you. Then you can put on your Aristotle hat and decide which ones suit your investing philosophy the best. You can even get a free trial.

Feel free to email me with stock picks you think would pass Aristotle's rigorous tests. And be on the lookout next week for investment advice from Copernicus.

For more on the companies shown above, check out:

• A Bigger Target
• 3 Stocks That Blew the Market Away
• Looking for the World's Best Stocks?

UnitedHealth is both a Stock Advisor and an Inside Value recommendation. Federal Express is also a Stock Advisor selection. Johnson & Johnson is an Income Investor pick.

Fool contributor Timothy M. Otte surveys the retail scene from Dallas. He welcomes comments on his articles, but doesn't own shares in any of the companies mentioned in this article. The Fool has a disclosure policy that is the height of reason.