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Everyone would love to find the perfect stock. But will you ever really find a stock that gives you everything you could possibly want?
One thing's for sure: If you don't look, you'll never find truly great investments. So let's first take a look at what you'd want to see from a perfect stock, and then decide if Reynolds American (NYSE: RAI ) fits the bill.
The quest for perfection
When you're looking for great stocks, you have to do your due diligence. It's not enough to rely on a single measure, because a stock that looks great based on one factor may turn out to be horrible in other ways. The best stocks, however, excel in many different areas, which all come together to make up a very attractive picture.
Some of the most basic yet important things to look for in a stock are:
- Growth. Expanding businesses show healthy revenue growth. While past growth is no guarantee that revenue will keep rising, it's certainly a better sign than a stagnant top line.
- Margins. Higher sales don't mean anything if a company can't turn them into profits. Strong margins ensure a company is able to turn revenue into profit.
- Balance sheet. Debt-laden companies have banks and bondholders competing with shareholders for management's attention. Companies with strong balance sheets don't have to worry about the distraction of debt.
- Money-making opportunities. Companies need to be able to turn their resources into profitable business opportunities. Return on equity helps measure how well a company is finding those opportunities.
- Valuation. You can't afford to pay too much for even the best companies. Earnings multiples are simple, but using normalized figures gives you a sense of how valuation fits into a longer-term context.
- Dividends. Investors are demanding tangible proof of profits, and there's nothing more tangible than getting a check every three months. Companies with solid dividends and strong commitments to increasing payouts treat shareholders well.
With those factors in mind, let's take a closer look at Reynolds American.
What We Want to See
Pass or Fail?
|Growth||5-Year Annual Revenue Growth > 15%||0.9%||fail|
|1-Year Revenue Growth > 12%||0.8%||fail|
|Margins||Gross Margin > 35%||46.5%||pass|
|Net Margin > 15%||11.9%||fail|
|Balance Sheet||Debt to Equity < 50%||63.2%||fail|
|Current Ratio > 1.3||1.16||fail|
|Opportunities||Return on Equity > 15%||19.0%||pass|
|Valuation||Normalized P/E < 20||13.09||pass|
|Dividends||Current Yield > 2%||5.9%||pass|
|5-Year Dividend Growth > 10%||13.0%||pass|
|Total Score||5 out of 10|
Source: Capital IQ, a division of Standard and Poor's. Total score = number of passes.
Reynolds American comes in with a score of 5. That middle-of-the-road performance shows the conflict investors have with high-dividend stocks that haven't seen much revenue growth lately.
Reynolds isn't the best-known cigarette maker out there, but its Camel and Kool brands certainly have their following. With $8.6 billion in revenue over the past 12 months, Reynolds has about half the sales of market leader Altria (NYSE: MO ) .
Unfortunately, the company has some shortcomings compared to its sin-stock peers. Its net margins fall well short of those of Altria and Lorillard (NYSE: LO ) , which obviously limits its profitability. Yet fellow low-margin maker Vector Group (NYSE: VGR ) sports a much higher dividend and has managed to grow its revenue by over 20% in the past year.
Moreover, the joint threat of litigation and government regulation constantly hangs over the industry. Lorillard in particular faces a potential disaster from a proposed ban on menthol cigarettes; Reynolds would also take a small hit from a menthol ban. That has pushed many investors toward Philip Morris International (NYSE: PM ) , whose foreign focus shelters it from the litigious environment domestically.
For income investors seeking stable payouts, Reynolds isn't a bad choice. Just be sure you're comfortable with the risks involved.
No stock is a sure thing, but some stocks are a lot closer to perfect than others. By looking for the perfect stock, you'll go a long way toward improving your investing prowess and learning how to separate out the best investments from the rest.
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