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 Cummins (NYSE: CMI ) 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 Cummins.
|Factor||What We Want to See||Actual||Pass or Fail?|
|Growth||5-Year Annual Revenue Growth > 115%||5.6%||fail|
|1-Year Revenue Growth > 12%||16.8%||pass|
|Margins||Gross Margin > 35%||23.7%||fail|
|Net Margin > 15%||7.6%||fail|
|Balance Sheet||Debt to Equity < 50%||19.8%||pass|
|Current Ratio > 1.3||1.95||pass|
|Opportunities||Return on Equity > 15%||24.4%||pass|
|Valuation||Normalized P/E < 20||20.78||fail|
|Dividends||Current Yield > 2%||1.1%||fail|
|5-Year Dividend Growth > 10%||21.3%||pass|
|Total Score||5 out of 10|
Source: Capital IQ, a division of Standard and Poor's. Total score = number of passes.
Cummins scores a middle-of-the-road 5. As a producer of engines, exhaust systems, and power generators, the company is a solid cyclical performer that has shown signs of recovering from the recent recession.
Cummins competes with Caterpillar (NYSE: CAT ) and Navistar (NYSE: NAV ) in its engine business, but unlike its competitors, Cummins doesn't produce its own vehicles. That business model has helped keep the company in a healthier financial condition, with much smaller debt loads than Caterpillar and Navistar.
Just as Deere (NYSE: DE ) sought to do with agricultural equipment, Cummins has taken advantage of strong demand in emerging markets. Earlier this year, the Wall Street Journal cited the company's success in building a presence in the Chinese and Indian markets. It has also moved to more fuel-efficient designs after identifying the need to upgrade its engine offerings.
With strong returns on equity and a healthy habit of raising dividends, Cummins has made a very good investment for shareholders, nearly quadrupling in the past two years. The stock won't sustain that pace, but long-term investors can expect good things as Cummins navigates the ups and downs of the economic cycle.
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.