Great stocks share three winning traits:
- They're self-funded. Top stocks produce bushels of free cash flow. ExxonMobil (NYSE: XOM ) and Pepsi (NYSE: PEP ) are perfect examples of this. Combined, they've produced around $50 billion in FCF over the past 12 months alone.
- They're growing fast. Big winners tend to attract customers and produce massive revenue growth, as offshore drilling contractor Transocean (NYSE: RIG ) has over the past five years.
- They possess sustainable advantages. Great stocks have the chops to fund growth and expand margins. Think of Apple (Nasdaq: AAPL ) and its near-monopoly in online digital music. Or Diageo (NYSE: DEO ) and its dominant liquor brands.
Every one of these firms is a great business. I highlight them here because history proves that, while low-priced businesses can make for good returns, reasonably priced great businesses can make you rich.
Cheap stocks, cheap returns
Consider Google. When the search king was preparing for its August 2004 IPO, hundreds of stocks sold for less than 15 times earnings. Why pick 15? Jeremy Siegel pegs the 130-year average P/E of the market at 14.45.
Google, selling for around 100 times earnings, wasn't anywhere near that. Investors adhering to the investapo's party line -- that pricey multiples are rarely rewarded -- opted out of Google and into "cheap" stocks. Bank of America (NYSE: BAC ) and Consolidated Edison (NYSE: ED ) , for example, which were trading for 12.3 and 14.6 times earnings, respectively, on the day of DoubleGoo's public debut.
But it was the cheapskates who went unrewarded. Bank of America and Con Ed have lagged Google and the market since the summer of 2004.
Great businesses, great returns
Were you to check my portfolio today, you'd see that I've finally learned my lesson; Google is too great a business to ignore. But it isn't the best stock idea I've ever seen.
That one is self-funded, growing fast, features sustainable advantages, and accounts for more than 20% of my portfolio. Here's why:
- Free cash flow exceeded $100 million over the trailing 12 months.
- Return on invested capital is nearing 40%.
- Operating margins are expanding dramatically, and net margin is up over 30%.
What really excites me, though, is that this stock, which commands less than $3 billion in market value, is about to enter a hypergrowth phase that could unleash tens of billions in additional value.
David Gardner agrees. He names this stock, which was first recommended in the July 2002 issue, at the top of his five best buys right now in Motley Fool Stock Advisor. Find out why with a 30-day free trial of the service. You'll get unfettered access to all of David's picks, and there's no obligation to subscribe.
This article was first published Feb. 27, 2008. It has been updated.
Fool contributor Tim Beyers had positions in Google's shares and 2010 LEAPs at the time of publication. Google is a Rule Breakers recommendation. Apple is a Stock Advisor selection. Bank of America and Diageo are Income Investor picks. The Motley Fool's disclosure policy would be the best-dressed disclosure policy if words didn't prefer to be naked.