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How to Spot Great Stocks

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. Here's a favorite method of mine: Build a list of wonderful companies, and then watch for their stocks to fall to compelling prices.

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. General Electric (NYSE: GE  ) and Microsoft (Nasdaq: MSFT  ) place among the top 10 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 Merck (NYSE: MRK  ) , for example, manufacture products that people will buy whether they're flush with funds or strapped for cash. (If you're losing bone mass, you're probably not going to forgo taking your Fosamax to save a few bucks.) Firms such as PepsiCo (NYSE: PEP  ) and Diageo (NYSE: DEO  ) offer consumers things they love. Ideally, look for products that people buy over and over again, such as cheeseburgers and shampoo, instead of items bought only sporadically, like cars or garbage disposals.

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. Johnson & Johnson, for example, has increased its revenues for some 73 consecutive years, hiked its dividend for 44 consecutive years, and posted double-digit earnings increases for 21 consecutive years. Now, isn't that attractive?

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 Boeing, for example. It has just one main competitor in the passenger airliner business -- Airbus. How likely is it to get another competitor? Not too likely. A company would have to spend a heck of a lot of money getting up to speed, what with required equipment and all. It would also need a lot of expertise quickly, and it would have to somehow earn the trust of airplane purchasers. That's a tall order. Similarly, any company that wanted to build a massive online marketplace would have trouble competing with eBay (Nasdaq: EBAY  ) -- it just has had too much of a head start and is too big.

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 can 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 is 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 (with no obligation). 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.

Learn more in these articles:

This article was originally published Sept. 15, 2006. It has been updated.

Longtime Fool contributor Selena Maranjian owns shares of Coca-Cola, Johnson & Johnson, Microsoft, PepsiCo, General Electric, and eBay. Microsoft and Coca-Cola are Motley Fool Inside Value recommendations. Diageo and Johnson & Johnson are Income Investor picks. eBay is a Stock Advisor selection. The Motley Fool is Fools writing for Fools.

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