If you want to be a wildly successful investor, you'll need to invest in wildly successful companies. (Or mutual funds, or apartment buildings, etc.) But zeroing in on the most promising companies is easier said than done. A favorite method of mine: Build a list of wonderful companies, and then watch for their stocks to fall to compelling levels.
To help you determine whether the company you're looking at is a first-class operation you'd be proud to have in your portfolio, here are five hallmarks of great companies:
1. Powerful brands
Think of well-known brand names in the United States or, better yet, around the world. Toyota (NYSE: TM), Dell, and Google (Nasdaq: GOOG) all place among the top 25 brands in the world, as ranked by Interbrand. This kind of popular recognition can give these companies a leg up in their industries.
2. Significant products or services
Look for a company that's selling its customers something they really need or really want. Pharmaceutical companies such as Schering-Plough (NYSE: SGP), for example, manufacture products that people will buy whether they're flush with funds or strapped for cash. (If you're fighting hepatitis, for example, you're probably not going to forgo taking your Rebetol to save a few bucks.) Firms such as Coca-Cola and Kraft Foods (NYSE: KFT) also offer consumers products they love and will purchase over and over again.
3. Consistent, reliable earnings and sales growth -- and robust margins
Great companies grow steadily and find ways to get more and more of their revenue to the bottom line.
4. Strong leadership
This is largely qualitative, but that doesn't mean you can't ferret out some useful impressions and information. Learn to spot good leaders with Foolish articles such as "Identifying Effective Management" and "Investigative Investing."
5. A lasting competitive advantage
Think of Time Warner and its AOL division. Any online service provider that gives people email addresses enjoys the competitive advantage of "switching costs." Once people have an email address through your company, they're not going to drop you for another provider very easily, since doing so will require the headache of having to alert all of their correspondents and updating their many accounts. You'll still lose some customers, but it will be harder for them to switch email providers than diet colas. Though AOL has struggled recently, it retains many loyal members. Despite increasing competition, cable companies such as Cablevision (NYSE: CVC) enjoy similar advantages. The hassle of switching keeps many customers in place -- or at least gives the cable companies the opportunity to upgrade their offerings.
And then there's price ...
Once you've identified a great company, you may be tempted to rush out and buy shares at any price. Don't. High-quality companies often trade at premium prices, and paying too much for a stock will hurt your returns. But if you're patient, you'll likely find one or more on sale every now and then. One very successful firm recently trading at a not-so-high price includes Coca-Cola. Coke's recent price-to-earnings (P/E) ratio, around 22, is well below its historical average.
Great companies at good prices. That's a recipe that can help you beat the market for decades, and it happens to be a good way to summarize the strategies that Fool co-founders David and Tom Gardner employ in their Motley Fool Stock Advisor investing service. To date, their picks are beating the S&P 500 by nearly 40 percentage points.
I encourage you to take advantage of a free trial of the service. It'll give you full access to all past issues, and you'll be able to see the entire list of recommended stocks and their subsequent performance.
This article was originally published Sept. 15, 2006. It has been updated.
Longtime contributor Selena Maranjian owns shares of Coca-Cola and Time Warner. Dell and Coke are Inside Value recommendations. Dell is also a Stock Advisor pick. And Kraft is an Income Investor selection. The Motley Fool is Fools writing for Fools.
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