The Perfect Stock

When it comes to risk, it's true that no stock is "perfect." Every single one of them goes up and down, and even the bluest of blue chips can bitterly disappoint you.

With that huge disclaimer out of the way, let's talk about what would make for a perfect stock -- at least, as perfect as possible. Some might lean toward a stable and safe large-cap blue chip like Johnson & Johnson (NYSE: JNJ), which I personally own because of the competitive advantages offered by its name-brand products, amazing dividend history, and long-term outperformance. J&J and its kind will rarely cause you to lose sleep at night.

Others may consider perfection to be a nerve-racking, rocketing small-cap multibagger -- the kind Tim Hanson wrote about in "The Market's 10 Best Stocks."

But I see the perfect stock as somewhere in between. I look for companies with market caps of less than $3 billion, so that the stock still has plenty of room to reach 10-bagger status. I also require some degree of stability and predictability, with little chance of a bankruptcy filing that would torpedo my portfolio.

For example
When I first wrote about this concept in 2006, I said my perfect stock would look just like Middleby -- the commercial oven maker and supplier to fast-food stars such as McDonald's and Wendy's. (Middleby is not perfect anymore, however; more on that later.)

I hadn't heard of this company until Tom Gardner recommended it in Motley Fool Hidden Gems in 2003. After watching it quadruple in value, I studied it closely and found three main traits that propelled it skyward:

1. Great leadership. Selim Bassoul rose through the company ranks, serving as president and chief operating officer of various subsidiaries before his promotion to CEO in 2001. He brought focus and business savvy to the top post, along with a strong emphasis on higher margins and consistent earnings growth.
2. Focus, especially on strong global trends. Bassoul's valuable experience led him to make a gutsy decision to abandon the idea of serving the entire kitchen. He jettisoned such products as coolers and refrigerated deli cases to concentrate solely on ovens and toasters. With all of its efforts thrown behind these high-margin and patentable products, Middleby has profited handsomely from the strong global trend of eating outside the home.
3. High insider ownership. Our preference for companies with high levels of insider ownership is well-documented. More managers and directors with significant stakes in the business mean more decision-makers whose interests are aligned with ours as individual shareholders. At the time, 25% of Middleby was owned by insiders.

Toss in the fact that it was an obscure company in a boring industry -- something legendary investor Peter Lynch loved -- and you can see why it was loaded with potential.

Here are some other companies with similar traits -- well worth further research:

Data from Capital IQ.

Any company with these traits selling at a reasonable valuation should garner serious consideration for your investment dollars.

Fast-forward
But alas, perfection does not always last -- and sadly, that was the case with Middleby. Over the past couple of years, several of our analysts have been questioning what seemed like excessive compensation for Bassoul.

The issue did not go away, and it really came to a head in recent months. Management's incentive plan has embarrassingly low hurdles to trigger bonus compensation, such as achieving return on equity levels of 10% to 12% over the next couple of years -- well below historical levels. It's probably no coincidence that insider ownership has fallen from 25% to 7%.

Hidden Gems recently sold Middleby off its scorecard, locking in gains of 400% from the original recommendation. As co-advisor Seth Jayson wrote in the sell report, big paydays, low hurdles, and a compliant board sealed the deal: "[We're] convinced that the board is at best shirking its oversight duty and at worst simply rubber-stamping and allowing Bassoul to write his own paycheck."

This illustrates a huge benefit that comes from following a stock closely for years. The story is shifting at Middleby, and we're more than happy to lock in big gains and wish the best of luck to those who continue to hold.

Going for the green
There are a handful of companies our analysts follow that fit my "perfect stock" criteria. One of them is the aforementioned China Green Agriculture, which is a "buy first" recommendation in our Million Dollar Portfolio. This maker of environmentally friendly fertilizer is currently trading at an attractive price. From the Million Dollar Portfolio buy report:

China is caught in a major agricultural bind. Already the world's largest producer and consumer of fertilizer, the country needs to increase farm yields to meet growing food demand, yet its arable land is plagued by the harsh impact of urbanization. Meanwhile, pollution in China's rivers and groundwater continues to fester, so the government is encouraging farms to replace their chemicals with green fertilizers.

China Green is just one company in MDP's "rural China basket" of stocks, designed to give you the proper amount of exposure to this fast-growing sector in a relatively low-risk way. If you'd like to see them, as well as others in the portfolio that fit my "perfect stock" definition, MDP will be opening again soon to new members. Click here and enter your email address to get more information.

This article was originally published March 26, 2010. It has been updated.

MercadoLibre is a Motley Fool Rule Breakers recommendation. Morningstar is a Stock Advisor selection. China Green Agriculture is a Global Gains pick. Johnson & Johnson is an Income Investor pick. The Fool has created a covered strangle position on Papa John's International. Motley Fool Options has recommended a diagonal call position on Johnson & Johnson. The Fool owns shares of Almost Family, China Green Agriculture, Johnson & Johnson, and Morningstar.

Rex Moore contributes the Foolish 8 screens to Hidden Gems. Of the companies mentioned in this article, he owns shares of Johnson & Johnson. True to its name, The Motley Fool is made up of a motley assortment of writers and analysts, each with a unique perspective; sometimes we agree, sometimes we disagree, but we all believe in the power of learning from each other through our Foolish community. The Motley Fool has a disclosure policy.