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. Novartis (NYSE: NVS ) and GlaxoSmithKline (NYSE: GSK ) are perfect examples of this. Combined, they've produced more than $13 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 Activision Blizzard (Nasdaq: ATVI ) has over the past three years.
- They possess sustainable advantages. Great stocks have the chops to fund growth and expand margins. Companies like Turkcell (NYSE: TKC ) , a leading cellular provider in Turkey. Or Hansen Natural (Nasdaq: HANS ) , a monster of an energy drink supplier.
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, cheaper 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. Like US Bancorp (NYSE: USB ) and Hitachi (NYSE: HIT ) , for example, which were trading for 14.5 and 11.3 times earnings, respectively, on the day of DoubleGoo's public debut.
But it was the cheapskates that went unrewarded. US Bancorp and Hitachi 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 $170 million during 2008.
- Return on capital is up over 40%.
- Operating margin is above 50%, and net margin exceeds 30%.
What really excites me, though, is that this stock, which commands less than $2 billion in market value today, 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 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 stock and options positions in Google at the time of publication. Google and Hansen Natural are Rule Breakers recommendations. Turkcell is a Global Gains pick. Activision Blizzard is a Stock Advisor selection. GlaxoSmithKline is an Income Investor recommendation. The Fool's disclosure policy would be the best-dressed disclosure policy if words didn't prefer to be naked.