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 Reynolds American (NYSE: RAI ) 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 Reynolds American.
What We Want to See
Pass or Fail?
|Growth||5-Year Annual Revenue Growth > 15%||0.1%||Fail|
|1-Year Revenue Growth > 12%||(0.3%)||Fail|
|Margins||Gross Margin > 35%||46.9%||Pass|
|Net Margin > 15%||15.6%||Pass|
|Balance Sheet||Debt to Equity < 50%||54.7%||Fail|
|Current Ratio > 1.3||1.09||Fail|
|Opportunities||Return on Equity > 15%||20.0%||Pass|
|Valuation||Normalized P/E < 20||16.07||Pass|
|Dividends||Current Yield > 2%||5.7%||Pass|
|5-Year Dividend Growth > 10%||9.6%||Fail|
|Total Score||5 out of 10|
Source: S&P Capital IQ. Total score = number of passes.
Since we looked at Reynolds American last year, the tobacco company kept the same score, with a slight drop in dividend growth offset by a nice increase in net margin. The industry has kept its strong dividends lately, although increased regulation poses a constant threat.
For years, cigarette stocks like Reynolds have posed a conundrum to investors. Their high yields are attractive, but fears of litigation risk and other negatives have kept some investors away. Meanwhile, though, the industry has stubbornly kept generating big profits year after year.
Reynolds and its peers, though, think that warnings have gone far enough. Along with Lorillard (NYSE: LO ) and Vector Group (NYSE: VGR ) , Reynolds filed suit to block a requirement to use more graphic warnings on cigarette labels. In November, the company won a reprieve as the court agreed that the restrictions violated the company's First Amendment freedom of speech rights and ruled that the requirements wouldn't take effect until the entire lawsuit is resolved.
Increased regulation seems to be a global trend. Many investors turn to non-U.S.-focused tobacco companies Philip Morris International (NYSE: PM ) and British American Tobacco (AMEX: BTI ) in the hopes of avoiding expensive U.S. litigation costs and oversight, but the Australian government is now clamping down on tobacco as well, with other countries potentially following suit.
Reynolds may never have the fast growth that it would need to reach perfection by these standards. But for patient, income-driven investors with some tolerance for a changing legal environment, Reynolds makes a reasonable stock for a well-balanced portfolio.
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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