Nowadays, it's hard to imagine any stock being truly great. But winners are out there waiting to be found. The best are likely to exhibit each of these three winning traits:
- They're self-funded. Top stocks produce bushels of free cash flow. America Movil (NYSE: AMX ) and Arcelor Mittal (NYSE: MT ) are perfect examples of this. Combined, they've produced more than $15 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 NetEase.com (Nasdaq: NTES ) has over the past five years.
- They possess sustainable advantages. Great stocks have the chops to fund growth and expand margins. Think of EMC (NYSE: EMC ) and its hammerlock on the data storage market, or Diageo (NYSE: DEO ) , with popular, tasty brands like Guinness and an unmatched distribution network.
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.
Johnson Controls (NYSE: JCI ) and PNC Financial (NYSE: PNC ) , for example, were trading for 13.4 and 12.7 times earnings, respectively, on the day of DoubleGoo's public debut. But the cheapskates ultimately went unrewarded. Johnson Controls and PNC have lagged both 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 $140 million over the trailing 12 months.
- Return on invested capital exceeds 40%.
- Operating margins are expanding dramatically, and net margin is up more than 30%.
What really excites me, though, is that this stock, which commands not much more than $2 billion in market value, is about to enter a hypergrowth phase that should unleash tens of billions in additional value.
David Gardner agrees. He's recommended this stock to Motley Fool Stock Advisor subscribers three times since the July 2002 issue. Learn why with a 30-day free trial to the service. You'll get unfettered access to all of David's picks, with no obligation to subscribe.
This article was first published Feb. 27, 2008. It has been updated.
Fool contributor Tim Beyers had stock and options positions in Google at the time of publication. Google and Netease.com are Rule Breakers recommendations. America Movil is a Global Gains pick. Diageo is an Income Investor selection. The Fool's disclosure policy would be the best-dressed disclosure policy, if words didn't prefer to be naked.