Back in 1995, when I had much more hair on my head -- but much less investing experience under my belt -- I discovered a promising little company that fit all my investing criteria. Although this company was young, it boasted a strong balance sheet, impressive free cash flow, and tremendous growth potential. Best of all, the company -- I'll reveal its name in a moment -- was run by a dedicated founder/CEO who also happened to be the single largest shareholder.
I happily bought shares, then even more happily sold a few months later, pocketing a tidy 25% profit. It was a textbook value investing success.
It was also the biggest investing mistake I've ever made.
I know what you're thinking
If you've lost money by following any of my stock recommendations over the last 15 years, you're surely wondering: How in the world I could consider a 25% gain the biggest investing mistake of my career? But rest assured, my experience with Dell (Nasdaq: DELL ) was more painful than suffering a dozen bankruptcies.
That's because after I sold my shares, Dell went on to increase 45 times in value over the next 10 years. Even though the company has been in a slump recently, it still trades at more than 18 times my sell price. That's the kind of multi-bagger return that can make an investing career -- or fund the retirement of your dreams, if you don't share my aspirations of being a master investor.
Fortunately, my Dell experience wasn't a complete waste. In fact, I learned a key lesson that has helped me identify other long-term winners and prevented me from selling them when they still had room to run. But before I get to that, let's examine what made Dell such a success in the first place.
Three keys to a great company
1. Customer Focus: Founder Michael Dell couldn't afford to build the fastest or most stylish personal computers -- he was operating out of his dorm room! Instead of trying to compete with the big boys, Dell concentrated on the one competitive advantage he could control: customer satisfaction. Thanks to its direct sales model, Dell could better understand its customers' wants and needs, and provide the PC that was right for them.
The great corporate leaders that I've met over the years, from Coach's (NYSE: COH ) Lew Frankfort to Southwest Airlines' (NYSE: LUV ) Herb Kelleher to Amazon.com's (Nasdaq: AMZN ) Jeff Bezos all share an unrelenting focus on delighting their customers. Coach conducts over 40,000 one-on-one customer interviews each year to make sure its handbags meet its customers' needs. Southwest only hires employees with a sense of humor, a creative streak, and a passion for helping passengers. Amazon prides itself on low prices, cheap shipping, and exceptional customer service.
It's no secret why these firms have been so successful -- and why I believe their success will continue in the future. They are willing to go above and beyond to delight their customers in ways the competition simply can't match.
2. Strong Financials: Of course, the greatest customer service in the world won't matter if the company doesn't have enough cash on hand to cover its electric bill. Although Dell's tremendous growth potential was apparent, I waited for the company to generate consistent free cash flow before I bought my shares. I was happy to sacrifice a slightly higher purchase price for the downside protection that comes with a proven cash generator.
In addition, Dell had a sound balance sheet, with a debt-to-equity ratio of about 20%. I don't mind when companies take on a little debt -- in fact, I think it can actually help executives invest their limited resources in the best projects. But too much debt can have the opposite effect, forcing execs to adopt an unhealthy short-term focus.
Just look at Chesapeake Energy (NYSE: CHK ) , which was forced to sell valuable assets during the credit crisis to shore up its balance sheet. Chesapeake may own a number of attractive shale positions, but its levered balance sheet makes it too risky for my liking. To avoid a similar fate, I generally steer clear of companies with debt-to-equity ratios in excess of 100%.
3. Insider Ownership: Last, but certainly not least, I was encouraged by Michael Dell's significant ownership position. I've found that high insider ownership is one of the most reliable indicators of stock market success. Founders and managers with high levels of ownership have their own wealth riding on the company's performance.
Michael Dell was the company's single largest shareholder, with an approximately 9% stake. Of course he was going to make decisions with shareholders' best interests in mind!
To see how many shares an executive owns, simply open up a company's latest proxy filing (also known as SEC Form 14-A). As a general rule of thumb, I like to see CEOs of small-cap companies own at least 5% of the outstanding shares. I'll relax this ownership restriction for larger companies (we can't realistically expect Rex Tillerson to own $15 billion worth of ExxonMobil (NYSE: XOM ) shares, can we?), but I still like to see execs of large-cap companies maintain an ownership stake of $10 million or more. Tillerson's $68 million position in his company, combined with his 35 years of experience and reasonable salary, gives me confidence that he will continue to serve ExxonMobil shareholders in the future.
Please bear in mind: High insider ownership does not always translate to stock market success. Ken Lay and Jeff Skilling both owned large amounts of Enron's stock, and look where that got shareholders. But when an executive owns a significant stake and has a history of shareholder-friendly behavior, the investing odds are stacked in your favor.
The best time to sell
The world's greatest investor, Warren Buffett, teaches us that the best time to sell a great company is never. I couldn't agree more. I have seen far too many investors miss out on multi-bagger returns because they missed the big picture and sold a stock due to short-term valuation concerns.
Just imagine if you had sold Microsoft in the 1980s when it was still a small- or mid-cap stock. Those investors with the foresight and patience to hold onto their shares were richly rewarded.
The stock you shouldn't sell
And that, dear Fools, is the invaluable lesson I learned from my Dell experience. When you have identified a company with the three keys to greatness -- customer focus, strong financials, and high insider ownership -- you shouldn't let short-term valuation concerns scare you away from multi-bagger returns.
That's the advice I'd give to investors who own shares of Dolby Laboratories (NYSE: DLB ) , one of the most successful recommendations I've made at Motley Fool Stock Advisor. Although Dolby has tripled since I first recommended the stock to Stock Advisor members in 2006, I think this audio entertainment pioneer still has plenty of room to run.
Dolby has a rock-solid balance sheet, with $779 million in cash and just $7 million in debt. The company generates strong and steady free cash flow, and it has great growth prospects as countries like China, India, and Russia make the transition to digital technology. And best of all, founder/CEO Ray Dolby owns over 50% of the company's shares.
I am confident that every decision Ray makes will be in his shareholders' best interests. I am also confident that those Dolby shareholders will be glad they held on to their stake in 10 years' time.
To read more about Dolby, as well as the other companies my brother David and I think you'd be smart to own for the next 10 years -- or more -- just click here to take a free 30-day trial of Motley Fool Stock Advisor. There is no obligation to subscribe. You have my word.
Fool co-founder Tom Gardner owns shares of Microsoft. Chesapeake Energy and Microsoft are Motley Fool Inside Value selections. Amazon.com, Coach, and Dolby Laboratories are Stock Advisor picks. The Fool owns shares of Chesapeake Energy and Microsoft. The Fool has a disclosure policy.