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 Arena Pharmaceuticals (Nasdaq: ARNA ) 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 Arena.
|Factor||What We Want to See||Actual||Pass or Fail?|
|Growth||5-year annual revenue growth > 15%||(4.7%)||Fail|
|1-year revenue growth > 12%||46.9%||Pass|
|Margins||Gross margin > 35%||53.3%||Pass|
|Net margin > 15%||NM||Fail|
|Balance sheet||Debt to equity < 50%||116%||Fail|
|Current ratio > 1.3||4.76||Pass|
|Opportunities||Return on equity > 15%||(121.1%)||Fail|
|Valuation||Normalized P/E < 20||NM||Fail|
|Dividends||Current yield > 2%||0%||Fail|
|5-year dividend growth > 10%||0%||Fail|
|Total Score||3 out of 10|
Source: Capital IQ, a division of Standard and Poor's. NM = not meaningful; Arena had negative net income during the period. Total score = number of passes.
Arena's score of 3 leaves it well short of perfect. But as with many start-up drug companies, Arena could see things get a whole lot better if its drug pipeline works out favorably.
In Arena's case, that future success relies on a single drug: lorcaserin. The drug helps fight obesity, which has become a popular area of research for a number of drug companies. Vivus (Nasdaq: VVUS ) has an obesity drug called Qnexa in development, while Orexigen's (Nasdaq: OREX ) Contrave also targets obesity.
Unfortunately for Arena, lorcaserin hasn't come up a winner in the Food and Drug Administration's approval process. Neither Arena nor Vivus could convince an FDA advisory panel to recommend approval of their drugs, as safety concerns outweighed the potential benefits. Given the FDA's past experience with Abbott Labs' (NYSE: ABT ) Meridia, which it removed from the market after safety concerns arose, it seemed likely that none of the obesity drugs under development would get through. But Orexigen got a positive nod from an advisory panel earlier this month, potentially opening the door to a huge market if the FDA follows the advisory panel's recommendation.
Despite its rejection, lorcaserin isn't dead in the water. But it's unclear what Arena will need to do to satisfy the FDA. In the meantime, if Contrave keeps its head start, lorcaserin might never catch up -- potentially leaving Arena as another upstart company that didn't live up to its promise.
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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