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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 have helped our team at Motley Fool Pro zero in on what makes for a winning business. Here are five of the key traits we seek in each stock before we buy it.
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 Southern Copper (NYSE: SCCO ) , one of the largest copper producers on the planet (the world isn't producing more copper anytime soon); or Wal-Mart (NYSE: WMT ) and SYSCO (NYSE: SYY ) , whose economies of scale over their respective distribution networks allow them to spread the same fixed costs over a wider revenue base and charge their customers lower prices.
eBay has sustainable competitive advantages, but it hasn't evolved quickly enough to keep all of its customers happy. However, its network effects -- buyers use eBay because that's where the sellers are, and vice versa -- 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 Colgate-Palmolive (NYSE: CL ) 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 Colgate, Speed Stick, or Ajax -- and the additional cost is small for them. Yet in aggregate, it's strong for Colgate-Palmolive.
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.
Revenue at the largest exchange company in the world, NYSE Euronext (NYSE: NYX ) , recurs whenever someone makes a stock or option trade on its exchanges. Elsewhere, insurance companies enjoy recurring revenue every time a policy is auto-renewed, which happens more than 80% of the time at the best providers. Software companies have also gotten wise; they now sell annual subscriptions to their wares.
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 businesses 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 Oracle (Nasdaq: ORCL ) and medical device giant Medtronic (NYSE: MDT ) . Both companies, incidentally, also enjoy many of the four other traits I've listed here.
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