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. Anadarko Petroleum (NYSE: APC ) and Merck (NYSE: MRK ) are perfect examples of this. Combined, they've produced nearly $7 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 Hologic (Nasdaq: HOLX ) has over the past five years.
- They possess sustainable advantages. Great stocks have the chops to fund growth and expand margins -- companies like First Solar (Nasdaq: FSLR ) , an early leader in solar cell production, or Diamond Offshore (Nasdaq: DO ) , which boasts an enviable position in deepwater oil drilling.
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 more than 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 Barclays (NYSE: BCS ) and Allstate (NYSE: ALL ) , for example, which were trading for 13.8 and 10.3 times earnings, respectively, on the day of DoubleGoo's public debut, according to Capital IQ.
But it was the cheapskates that went unrewarded. Barclays and Allstate 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 learnt 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 $2.2 billion in market value today, is about to enter a hypergrowth phase that should unleash tens of billions in additional value.
Fool co-founder David Gardner agrees. Three times he's recommended this stock to Motley Fool Stock Advisor subscribers since the July 2002 issue. Learn which stock I'm talking about and why it earned David's confidence with a 30-day free trial to 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 is a Rule Breakers recommendation.
Check out Tim's portfolio holdings and Foolish writings, or connect with him on Twitter as @milehighfool. The Motley Fool is also on Twitter as @TheMotleyFool. The Fool's disclosure policy would be the best-dressed disclosure policy if words didn't prefer to be naked.