Everyone would love to find the perfect stock. But will you ever really find a stock that gives you everything you could possibly want?
One thing's for sure: If you don't look, you'll never find truly great investments. So let's first take a look at what you'd want to see from a perfect stock, and then decide if KKR Financial (NYSE: KFN ) fits the bill.
The quest for perfection
When you're looking for great stocks, you have to do your due diligence. It's not enough to rely on a single measure, because a stock that looks great based on one factor may turn out to be horrible in other ways. The best stocks, however, excel in many different areas, which all come together to make up a very attractive picture.
Some of the most basic yet important things to look for in a stock are:
- Growth. Expanding businesses show healthy revenue growth. While past growth is no guarantee that revenue will keep rising, it's certainly a better sign than a stagnant top line.
- Margins. Higher sales don't mean anything if a company can't turn them into profits. Strong margins ensure a company is able to turn revenue into profit.
- Balance sheet. Debt-laden companies have banks and bondholders competing with shareholders for management's attention. Companies with strong balance sheets don't have to worry about the distraction of debt.
- Money-making opportunities. Companies need to be able to turn their resources into profitable business opportunities. Return on equity helps measure how well a company is finding those opportunities.
- Valuation. You can't afford to pay too much for even the best companies. Earnings multiples are simple, but using normalized figures gives you a sense of how valuation fits into a longer-term context.
- Dividends. Investors are demanding tangible proof of profits, and there's nothing more tangible than getting a check every three months. Companies with solid dividends and strong commitments to increasing payouts treat shareholders well.
With those factors in mind, let's take a closer look at KKR.
What We Want to See
Pass or Fail?
|Growth||5-Year Annual Revenue Growth > 15%||39.3%*||pass|
|1-Year Revenue Growth > 12%||(10.7%)*||fail|
|Margins||Gross Margin > 35%||98.9%||pass|
|Net Margin > 15%||81.5%||pass|
|Balance Sheet||Debt to Equity < 50%||527.6%||fail|
|Current Ratio > 1.3||170.96||pass|
|Opportunities||Return on Equity > 15%||25.7%||pass|
|Valuation||Normalized P/E < 20||9.03||pass|
|Dividends||Current Yield > 2%||5.3%||pass|
|5-Year Dividend Growth > 10%||(30.2%)**||fail|
|Total Score||7 out of 10|
Source: Capital IQ, a division of Standard and Poor's. *Net interest income growth; 39.3% is annual growth rate since Dec. 2005. **Growth since March 2006. Total score = number of passes.
KKR scores an impressive 7. As a company that specializes in debt financing and investments the same way that private equity firms Blackstone (NYSE: BX ) and Fortress Investment (NYSE: FIG ) specialize in equity financing, KKR has had a rocky road but now finds itself in an amazingly supportive environment for its bond holdings.
KKR's business primarily involves borrowing against short-term credit facilities in order to buy collateralized loan obligations, taking advantage of interest rate spreads to create profits. Much like how Chimera Investment (NYSE: CIM ) and Hatteras Financial (NYSE: HTS ) do with mortgage debt, KKR earns the most when those spreads are wide, as they have been lately.
That's quite a turnaround from 2007 and 2008, when the subprime crisis threw a huge wrench into the credit markets. KKR lost more than $1 billion in 2008, forcing it to slash its dividend. But over the past 12 months, it's reversed that loss to a profit of nearly $280 million.
The main challenge for KKR is navigating what many are calling a bubble in the bond market. If rate spreads decrease, so too could KKR's profits. For now, though, the company is making hay while the sun shines.
No stock is a sure thing, but some stocks are a lot closer to perfect than others. By looking for the perfect stock, you'll go a long way toward improving your investing prowess and learning how to separate out the best investments from the rest.
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