Stocks 2004: Road Map to Great Companies

There are more than 6,000 companies listed on the three major American stock exchanges. Many of them -- most of them -- you've never heard of. And although I can't say with any conviction that most of them are not worth your investment dollars, I can say with a great deal of conviction that many of them are not. Unfortunately, this same scientifically precise measurement -- "many" -- is how many of these companies sit in the average person's portfolio.

Why is that?

A number of reasons, actually, some of which are specific to the company, and some of which are specific to you. This past year, as we do each year, our crack team of Motley Fool analysts set out to pick companies that we thought offered intriguing investment potential in our Stocks 2004 publication. These companies come from diverse areas -- biotechnology, construction materials, entertainment, restaurants, health care, and investment management among them. But these 12 companies had a few elements in common that allowed us to select them over the other 99.98% of companies that we otherwise could have selected.

The results for the one-year period were solid for our Stocks 2003 compilation. Let me take a little bit of the "how'd we do it" suspense away right now. Selections returned better than 39%, well above the S&P 500's return of 15%. Of course, a year is really a very, very short period of time when it comes to businesses. You can make a good investing decision and have to wait years for it to be rewarded. It happens. That it didn't this year for us has as much to do with fortune as it does with good investing acumen. This is something that you will hear from nowhere else when they trumpet their one-year (or shorter) results.

But good investing results also come from making good investing decisions. The timing of the results may be due to providence; the fact of the results comes from within. Famous poker player Puggy Pearson says that the key to winning at cards is simple -- it's recognizing the side of a bet with the best odds and being on that side. So, our selections in 2003, as they are in 2004, are based largely upon situations where we have determined that we're putting our money on the side of the odds with the best chance of succeeding. This, of course, means that in every year there will be long-shot odds that pay off that will beat us badly. We don't care a whit about that, because, again, to the betting analogy, fast and strong may not always win the race, but it's the best way to wager. Fast, strong, and underappreciated is best of all.

What's fast and strong in investing? Who's underappreciated? These are elements we look for in companies we select. In Stocks 2004, you'll find companies with the following attributes:

1. Powerful cash flows. We say this every time we can. A company that produces boffo free cash flow is one that will always interest us, even if it gets eliminated for other reasons. From last year's selections, Cemex (NYSE: CX  ) had this attribute in spades, generating massive amounts of cash flow that it was using to pay down old debt, buy other businesses, or even return to investors. Cemex -- a boring old cement manufacturer from Mexico, returned nearly 20% on the year, and its debt is substantially lower at the end of the period than it was in the beginning. In Stocks 2004, we've found another firm in a similar position -- new, smart management at a retail company we've all heard of using previously untapped operating strength to generate returns that Wall Street is yet to appreciate.

2. Excellent capital structure. Cemex has debt -- without its cash flows and a show of determination by management to pay it down aggressively, it would not have made the cut. Quality Systems (Nasdaq: QSII  ) and Alliance Capital (NYSE: AC  ) , on the other hand, had balance sheet power that made us giddy. Quality Systems nearly doubled during the year, while Alliance Capital, one of the companies implicated in the mutual fund scandal of late, underperformed. It may continue to do so, it may not. But it goes to show that dynamic situations such as corporate performance can always throw you curveballs. You always split aces in blackjack. You don't always win. This year, we have several companies that offer beautiful balance sheets -- plenty of cash with which to fund growth, and either no debt, or a trace amount that shows that leverage is being used by choice, not by necessity.

3. Unparalleled management. Our Alliance Capital experience shows that this element, often extremely difficult to analyze, is crucial. We seek shareholder-centric management. We shun companies that have corporate headquarters that look like national monuments, with Picassos on the walls and overpriced suits in immaculately appointed offices. We like CEOs who fly coach. We like CEOs with the modesty of Berkshire Hathaway's (NYSE: BRK.A  ) Warren Buffett. And in Stocks 2004, as in Stocks 2003, companies that issue stock options as if they are free were not considered.

4. Growth Opportunities. Would you prefer to invest in Wal-Mart (NYSE: WMT  ) today or a decade ago? Obviously such hindsight wisdom doesn't offer much more than "shoulda, woulda, coulda." Also, looking for the "next Wal-Mart" is a fool's errand, and we're not talking about one swaddled in motley. LouAnn Lofton, for Stocks 2004, found a retailer turning in excellent same-store results, 20% growth, and a majority of its stores located in just two states. There is nothing saying that it can't stumble, but guess what? This company also possesses the three preceding qualities in spades.

5. Our own interest. This may be the most important attribute of all. It also means that our lists are necessarily personal in nature. Fool co-founder David Gardner likes video games, and his Stocks 2003 selection, Activision (Nasdaq: ATVI  ) reflected that passion. Asking David to come up with a company that makes ball bearings would be crazy -- in a million years he couldn't get interested in them, and that could lead to his missing signs of a business in decline. In Stocks 2004, we do believe that there is something for everyone. And if you happen to be passionate about ball bearings, take heart. In contrast to what Wall Street would have you believe, companies that don't attract interest from others are a good thing. It means that a potential bargain has yet to be appreciated by the market. Eventually, it will be.

Will we achieve the same results in 2004 as we did in 2003? That's not for me to say -- and it could be that the tailwind we had in 2003 will disappear or even reverse in 2004. All we can do is continue to play the odds, be disciplined, not chase high-return, low-probability situations, and be vigilant for changes. That's what we offer you each year.

You can find out more about our Stocks 2004 publication right here.

Foolish best!

Bill Mann
Editor, Stocks 2004

Bill Mann owns shares of Cemex.


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