5 Traits of Great Stocks

A 2009 study revealed that, in aggregate, three of four stocks on the U.S. markets lost value between 1980 and 2008, even though the S&P 500 returned 10.4% annualized. That means the winning stocks won big and compensated for the overwhelming number of losing stocks. But if you hope to be invested in the winners, you need to choose carefully.

More than two decades of investing experience has helped Motley Fool Million Dollar Portfolio zero in on what makes for a winning business. Here are five key traits to look for when considering a stock.

1. Sustainable competitive advantage
Healthy profits in a business attract competition -- everyone wants a piece of the profit pie. The only way a company can maintain profit margins and grow is to have a sustainable competitive advantage that serves as a protective moat around the business.

You hear a lot of people talk about this quality, from Warren Buffett on down, but many investors still fail to buy companies that sustainably meet the bill. That's because it's the rare company that truly has lasting advantages.

But they are out there. They're usually midsized or larger ($5 billion and up), have a long history of steady growth, and own assets or market share that provide enduring advantages over all others that are in the field or may enter it.

Think Rio Tinto (NYSE: RTP), one of the largest commodity mining operations on the planet (the world isn't producing more minerals anytime soon), or Laboratory Corporation of America (NYSE: LH  ) , which has client relationships going as far back as 1971 and has more than 1,500 patient-service centers in convenient locations.

Microsoft (Nasdaq: MSFT  ) has some sustainable competitive advantages, but it hasn't evolved quickly enough to keep all of its customers happy. However, network effects and switching costs -- competitive advantages -- are buying it time to right the ship.

2. Diverse customer base
A competitive advantage isn't worth much if the business depends on only a few customers. We like our businesses to have widely diverse and growing customer bases. That way, when a company loses some customers, it doesn't find itself in peril and will continue to grow. We shy away from buying companies where just one or two customers account for 5% or more of annual sales, even if the primary customer is a big name -- the government, for example.

3. Pricing power
When it has a lasting competitive edge and a broad customer base, a company usually enjoys some degree of pricing power. When costs rise, the company can pass them on to customers rather than suffer them internally. The strongest companies can implement modest price increases every few years without losing or alienating customers. Pricing power gives a company one more important arrow in its quiver as it hunts for long-term annualized growth.

When Procter & Gamble (NYSE: PG  ) ticks up the price on some products by a dime, do customers defect? Most don't, because they're buying a brand they favor -- be it Tide, Pringles, or Gillette -- and the additional cost is small for them. Yet in aggregate, it's strong for P&G.

4. Significant recurring revenue
If a business enjoys our first three criteria and also has significant recurring revenue, we become even more interested. By recurring revenue, we mean sales that repeat almost automatically, often with the same customers again and again, and usually without any need for the company to invest more money on marketing or reinventing itself or its products.

A majority of revenue at Oracle (Nasdaq: ORCL  ) recurs whenever a customer renews a software license, usually on an annual basis. Elsewhere, insurance companies enjoy recurring revenue every time a customer auto-renews a policy -- and auto-renewals happen more than 80% of the time at the best providers. More and more companies are getting wise to "annuitized" revenue and selling annual subscriptions to their wares or services.

When General Motors and Chrysler collapsed in the first major recession in years, we were reminded that automakers are an example of anything but easy recurring revenue. They need to advertise continually to drive each sale. As a result, they run expensive business that find themselves vulnerable when the economy stumbles.

Easily or "naturally" recurring revenue results in more predictable and more profitable results, and it helps maintain a business even during recessions.

5. Expanding free cash flow
The qualities we've mentioned so far will usually lead to strong free cash flow, which is the lifeblood of any company. Free cash flow is cash from operations minus capital spending and any other nonoperational cash income, such as tax benefits from stock options. These numbers are much more reliable than mere earnings-per- share data, and we generally look for free cash flow that's growing by at least 8% to 10% annualized over the long term.

No company grows in a straight line, but over time we want expanding free cash flow to drive the value of the businesses we own. Strong free-cash-flow growers over recent years include Gilead Sciences (Nasdaq: GILD  ) and credit-card giant Visa (NYSE: V  ) . Meanwhile, a rebound in free cash flow can revitalize a company, as it has at Open Text (Nasdaq: OTEX  ) , which has more than tripled its share price over the past handful of years. All three companies, incidentally, also enjoy many of the four other traits I've listed here.

If you'd like to know the other key traits that Motley Fool Million Dollar Portfolio demands, and see what the team is buying now, you have a chance to take a look for a few days. To keep membership manageable, Million Dollar Portfolio hasn't become available to new members since October 2009, and we don't know when we'll open our doors again. So come on in while you can, and see what the fuss is all about -- just click here and enter your email address in the box to learn more.

Jeff Fischer is advisor to Motley Fool Pro and Motley Fool Options. He doesn't own shares of any companies mentioned. Microsoft is a Motley Fool Inside Value recommendation. Open Text is a Motley Fool Rule Breakers pick. Laboratory Corporation of America Holdings is a Motley Fool Stock Advisor recommendation. Procter & Gamble is a Motley Fool Income Investor choice. The Fool owns shares of and has written covered calls on Procter & Gamble. Motley Fool Options has recommended a diagonal call position on Microsoft. The Fool owns shares of Microsoft, Open Text, and Oracle. 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.


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