Has KKR Financial Become the Perfect Stock?

Every investor would love to stumble upon the perfect stock. But will you ever really find a stock that provides everything you could possibly want?

One thing's for sure: You'll never discover truly great investments unless you actively look for them. Let's discuss the ideal qualities of a perfect stock, then decide if KKR Financial (NYSE: KFN  ) fits the bill.

The quest for perfection
Stocks that look great based on one factor may prove horrible elsewhere, making due diligence a crucial part of your investing research. The best stocks excel in many different areas, including these important factors:

  • 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 mean nothing if a company can't produce profits from them. Strong margins ensure that company can turn revenue into profit.
  • Balance sheet. At debt-laden companies, banks and bondholders compete with shareholders for management's attention. Companies with strong balance sheets don't have to worry about the distraction of debt.
  • Money-making opportunities. Return on equity helps measure how well a company is finding opportunities to turn its resources into profitable business endeavors.
  • Valuation. You can't afford to pay too much for even the best companies. By using normalized figures, you can see how a stock's simple earnings multiple fits into a longer-term context.
  • Dividends. For tangible proof of profits, a check to shareholders every three months can't be beat. 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 KKR Financial.

Factor

What We Want to See

Actual

Pass or Fail?

Growth

5-year annual revenue growth > 15%

24.3%

Pass

 

1-year revenue growth > 12%

37.8%

Pass

Margins

Gross margin > 35%

100%

Pass

 

Net margin > 15%

76.5%

Pass

Balance sheet

Debt to equity < 50%

386.2%

Fail

 

Current ratio > 1.3

43.86

Pass

Opportunities

Return on equity > 15%

23.8%

Pass

Valuation

Normalized P/E < 20

5.98

Pass

Dividends

Current yield > 2%

8.9%

Pass

 

5-year dividend growth > 10%

(17.6%)

Fail

       
 

Total score

 

8 out of 10

Source: S&P Capital IQ. Total score = number of passes.

Since we looked at KKR Financial last year, the company has seen some improvement from its score of seven. Revenue growth has come back with a vengeance in a strong market for debt financing and investments for the real estate investment trust.

Because of its high yield, KKR Financial often gets lumped in with mortgage REITs Annaly Capital (NYSE: NLY  ) and American Capital Agency (Nasdaq: AGNC  ) . But KKR Financial's business is quite different, more closely resembling that of private equity companies like Fortress Investment (NYSE: FIG  ) , Blackstone (NYSE: BX  ) , and the affiliated Kohlberg Kravis Roberts (NYSE: KKR  ) . Unlike private equity, KKR Financial focuses on buying up collateralized loan obligations rather than making equity investments.

Still, the same favorable rate spreads that have boosted mortgage REIT profits have also benefited KKR Financial. Because the company uses short-term credit facilities as investment capital on longer-term CLOs, it prefers steep yield curve environments -- and with the Federal Reserve giving a green light to super-low short-term rates until mid-2013, that bodes well for KKR Financial.

With a business model that requires leverage, KKR Financial may well never reach perfection by our definition. But as long as the interest rate party lasts, investors will likely keep on collecting big dividends from the company -- and that's as close to perfect as they may need to get.

Keep searching
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.

Click here to add KKR Financial to My Watchlist, which can find all of our Foolish analysis on it and all your other stocks.

Finding the perfect stock is only one piece of a successful investment strategy. Get the big picture by taking a look at our "13 Steps to Investing Foolishly."

Fool contributor Dan Caplinger doesn't own shares of the companies mentioned. The Motley Fool owns shares of Annaly Capital Management. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool has a disclosure policy.


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