The Holy Grail of Investing

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Within the stock market hide an elite group of businesses. They walk, talk, and act like regular companies, but they're much more valuable than their business brethren. These firms need little capital or cash flow to grow, and they buy shares back. Investors who latch onto these superstocks during rare occasions of reasonable valuations may be rewarded with years of strong returns.

How do we find these incredible firms? Here's what to look for:

• Low capital intensity: Some businesses need little capital to grow. For example, mutual fund firm Legg Mason (NYSE: LM) doesn't require a lot of capital. It doesn't have to build manufacturing plants or distribution centers -- to simplify, it only needs "two guys and a Bloomberg."
• "No strings attached" growth: When a business's cash flow grows, the business becomes more valuable. However, some businesses can grow without reinvesting their excess free cash flow. For example, when Legg Mason acquires additional customers, its business structure means it doesn't need to build more stores or plants.
• Share buybacks: The only thing better than owning a great company is owning more and more of it every year.

Turbocharged returns
If a company can grow its cash flow, it'll become more valuable over time. If it can simultaneously throw off free cash flow and repurchase its own shares, that'll really juice investor returns.

To illustrate this, let's imagine a company we'll call HolyGrailCo. It grows free cash flow (defined as operating cash flow, minus capital expenditures and the maintenance funds the company needs to maintain its existing operations) at 9% a year. If its valuation multiple stays the same, its share price should increase 9% a year. But if this growth doesn't require reinvestment, then management has the option to buy back its own shares. If this company happens to trade at 10 times free cash flow, management could buy back 10% of its own shares a year.

If HolyGrailCo buys back 10% of its shares in a year, then the earnings it once split 10 ways are now split only nine ways. Combine this with the 9% growth in free cash flow, and assuming multiples stay constant, HolyGrailCo shares' intrinsic value should increase by 21% per year (1.09/.9 = 1.21). In the long run, share prices should appreciate at about the same pace.

Keep in mind, this alchemy only works if you're dealing with great companies that fit the criteria of high returns on capital (and thus a wide moat), low capital intensity, and steady growth. Most importantly, they've got to trade at reasonable valuations. If the company suffers from a declining business or has overvalued shares, it'd make more sense for management to pay out excess capital in dividends, rather than buybacks.

A real-world example
A couple of quotes taken from Berkshire Hathaway's (NYSE: BRK-A) (NYSE: BRK-B) 1985 annual report demonstrate just how potent the combination of buybacks and growing intrinsic value can be:

Kay Graham, CEO of [Washington Post (NYSE: WPO)], had the brains and courage to repurchase large quantities of stock for the company at those bargain prices, as well as the managerial skills necessary to dramatically increase business values ... If we had invested our $10.6 million in any of a half-dozen media companies that were investment favorites in mid-1973, the value of our holdings at yearend would have been in the area of $40-$60 million... The extra $160 million or so we gained through ownership of WPC came, in very large part, from the superior nature of the managerial decisions made by Kay...

Win-win
Best of all, investors actually win if shares go down -- at least to a certain degree. If shares go down, management can buy back more of them, and per-share intrinsic value increases more quickly. If shares go up, buybacks become less attractive, but investors have already realized the goal of improved returns. Nothing could be better than this "heads I win, tails I win" situation.

Where to look
Due to the credit crunch, many businesses that combine a solid foundation, sustainability, and share repurchases now trade at reasonable valuations for the first time in many years. Fools should watch these companies carefully for buying opportunities.

I'd keep an eye out on Sears Holdings (Nasdaq: SHLD), US Bancorp (NYSE: USB), Moody's (NYSE: MCO), Torchmark (NYSE: TMK), and American Express (NYSE: AXP). These companies exhibit strong competitive advantages, a penchant for share buybacks, healthy growth, and reasonable valuation multiples.

Based on the qualities I've listed above, I think all of these stocks are very close to "fat pitch" territory.

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