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 whether Southwest Airlines (NYSE: LUV ) 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 Southwest.
|Factor||What We Want to See||Actual||Pass or Fail?|
|Growth||5-Year Annual Revenue Growth > 15%||10.0%||fail|
|1-Year Revenue Growth > 12%||12.8%||pass|
|Margins||Gross Margin > 35%||25.6%||fail|
|Net Margin > 15%||3.8%||fail|
|Balance Sheet||Debt to Equity < 50%||58.6%||fail|
|Current Ratio > 1.3||1.27||fail|
|Opportunities||Return on Equity > 15%||7.9%||fail|
|Valuation||Normalized P/E < 20||20.68||fail|
|Dividends||Current Yield > 2%||0.1%||fail|
|5-Year Dividend Growth > 10%||0.0%||fail|
|Total Score||1 out of 10|
Source: Capital IQ, a division of Standard and Poor's. Total score = number of passes.
Southwest garners only a single point on this scale, putting just about as far away from perfect as you can get. But more than anything, this shows what a tough business the airline industry is, as Southwest has done an impressive job just to make money at all.
Looking at Southwest's competitors puts the no-frills airline in a much better light. US Airways (NYSE: LCC ) and Delta Air Lines (NYSE: DAL ) are both drowning in debt, with debt levels of 60 times and 20 times shareholder equity respectively. United Continental (NYSE: UAL ) and American Airlines parent AMR (NYSE: AMR ) have negative equity.
Compared with them, Southwest has managed to post annual profits for 36 consecutive years and appears well on its way to adding a 37th. Unlike its major competitors, it pays a modest dividend. And while its margins are scant, they're better than the competition -- as is the company's healthy balance sheet. Moreover, Southwest's recent bid to acquire AirTran (NYSE: AAI ) could help it return to faster growth.
With JetBlue (Nasdaq: JBLU ) having suffered big setbacks in the past few years, Southwest remains the only proven viable airline. That doesn't mean it's the perfect stock, though. It's entirely possible that in the airline industry, there will be no winners at all.
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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