The Simple Way to Find Market-Beating Stocks

If you ask me, every investor should get the phrase "Keep it simple, stupid!" tattooed somewhere that makes it easy to glance at 50 times per day (give or take a few).

A lot of heartache could be avoided with this strategy. Take the financial crisis for instance. Complicated Wall Street models told the wonks in New York that it was A-OK to keep right on cooking up mortgage derivatives in 2006 and 2007. If they all had my suggested tattoo then they all would have looked up from their models, rubbed their eyes, and said "None of this makes a lick of sense." Crisis averted.

While I haven't gotten myself inked up quite yet, I do try to remind myself on a regular basis to get my head out of the books and newspapers, close my Excel models, and simplify things.

To get really basic, let's start with the goal of beating the market. Now how are we going to do that? In the simplest terms, we need to focus on four things: Company growth, valuation, dividends, and share growth.

Four to score
Each item in that list plays its own part in determining just how much you're going to cash in on your investment.

  • Growth: In most cases we're talking about profits here. We can easily see how much Gary's Gumbo Shack earns today, but how much will it be banking five years from now?
  • Valuation: No spreadsheets here, we're talking specifically about the multiple of earnings investors are willing to pay for a stock. If investors are paying 20 times earnings for Gary's today, do we think it's likely that they'll award the same multiple five years hence?
  • Dividends: If a company makes it a practice to pay out its profits to investors, then the total dividends that you think you'll collect will be a key component of your returns.
  • Share growth: Some companies need to issue new shares to fund the business, some pay their employees with stock, others buy back shares hand over fist. If there are more shares outstanding five years from now, that'll provide a drag on returns, while a lower share count will be a tailwind.

Simplicity in action
Potash Corp
(NYSE: POT  ) has been an absolute monster performer over the past decade, returning an amazing 1,158% (including dividends).

These returns were a result of the four items outlined above. Over that period, the company's operating earnings have grown 571% as a result of a 171% increase in revenue and an operating margin that expanded from 15% to 38%. At the beginning of 2001, investors were willing to pay 22 times Potash Corps' trailing earnings per share for the stock, while today they're coughing up 31 times earnings.

Potash Corp doesn't pay a huge dividend, but over ten years it's returned $790 million -- or $2.64 per share -- through its dividends. Meanwhile, the company has used cash flow to make a few large share buybacks and has lowered its share count by 4%.

Put those four points together and you get the stock's hefty return. Looking ahead, the math will be very similar. How fast will Potash Corp be able to grow earnings? How much will investors pay for those earnings? Will cash flow continue to be used to pay dividends and lower the share count?

Don't get me wrong, answering these questions is far from easy -- we're talking about the future after all. But these four points give us a very simple starting point to figure out whether a stock is a worthwhile investment.

The four-point plan
As an investor, you don't have to rely on all four points for your returns. Growth investors can spend most of their time figuring out the potential for earnings growth, while dividend investors would focus on, well, dividends. Heck, Autozone (NYSE: AZO  ) has produced stellar returns largely through aggressively buying back shares -- something that it continues to do today.

That said, all four points still need to be attended to. A growth investor, for example, may correctly identify a stellar grower, but end up with lousy returns because they paid too much for that growth (ask Sanofi-Aventis shareholders about that).

As for me, my forte is dividends, so my four-point-based search would start there with a requirement of a 3%-or-better dividend yield. While investors can certainly pay a higher multiple for an already-high-multiple stock, it's generally more likely that they'll award a higher multiple to a low-multiple stock, so I want a forward price-to-earnings multiple of 12 or less. I don't want a shrinking business, so I'll require analyst-estimated growth of 7%. Finally, I don't want any companies that have grown their share count at a faster pace than 2% per year over the past five years.

Here are five of the names that popped up using those criteria.

Company

Dividend Yield

Forward P/E

Expected Long-Term Earnings Growth

5-Year Share Count CAGR

H&R Block (NYSE: HRB  ) 4.6% 10.3 10% (0.5%)
Altria (NYSE: MO  ) 6.2% 12 7.5% (0.1%)
Intel (Nasdaq: INTC  ) 3.4% 10.5 10.9% (1.6%)
Lockheed Martin (NYSE: LMT  ) 3.7% 11.5 7.6% (3.7%)
R.R. Donnelley & Sons (NYSE: RRD  ) 5.5% 10.2 9.5% (1%)

Source: Capital IQ, a Standard & Poor's company.

The stocks above are all starting points for more research. That research should focus on pressure-testing the implied assumptions of the numbers above. Are the companies' balance sheets strong enough to continue to pay those -- or, better yet, higher -- dividends and not have to issue new shares? Might investors pay a higher multiple for their earnings in the future? Are those growth rates achievable?

As I noted above, that research may not always be particularly easy, but the approach is simple. And in what can be a very overwhelming world of investing, a little simplicity can go a long way.

Want more simplicity? My fellow Fools picked one stock as their top pick for 2011. Check out this free special report to find out the identity of that mystery stock.

Intel is a Motley Fool Inside Value selection. The Fool owns shares of and has bought calls on Intel. Motley Fool Options has recommended buying calls on Intel. The Fool owns shares of Altria Group and Lockheed Martin. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.

Fool contributor Matt Koppenheffer owns shares of Intel, but does not own shares of any of the other companies mentioned. You can check out what Matt is keeping an eye on by visiting his CAPS portfolio, or you can follow Matt on Twitter @KoppTheFool or on his RSS feed. The Fool's disclosure policy prefers dividends over a sharp stick in the eye.


Read/Post Comments (16) | Recommend This Article (37)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On February 16, 2011, at 4:13 PM, pryan37bb wrote:

    I've been holding Altria since May of last year, it hasn't been stellar, returning about 16% including dividends (not reinvested). In my portfolio it's a middle-of-the-pack performer, and in retrospect PM would have been a much better pick, as it gained about 25% with about the same yield as Altria at the time. On top of that, PM has nothing to worry about concerning the FDA and class-action suits in the US since they're strictly overseas, whereas Altria is strictly USA. Regardless, I think MO is due to break out soon, it's still trading rather cheap relative to the other tobacco giants. And you can't argue with that yield, especially for younger investors who are best poised to take advantage of compounding through a DRIP.

  • Report this Comment On February 16, 2011, at 5:26 PM, mikecart1 wrote:

    pryan37bb,

    MO is far better than PM. MO has made me lots of money and the dividends have given me a ton of shares extra through reinvestment. If you ask me, you can never have too much of MO!

  • Report this Comment On February 16, 2011, at 7:00 PM, Bonefish100 wrote:

    C'mon guys, enough already with so many recommendations above a P/E of 30, such as RRD!

  • Report this Comment On February 16, 2011, at 7:24 PM, TMFKopp wrote:

    @Bonefish100

    If you're looking at the P/E listed on Yahoo!Finance, you need to look a little deeper. For the 12 months ending in September RRD had significant restructuring charges which hopefully won't be repeated (though, to be fair, restructuring charges have been a familiar sight for RRD investors over the years). A look at the company's free cash flow confirms that the company is bringing in a lot more money than the GAAP net income over the last 12 months would suggest.

    As the table above shows, expected earnings for the next twelve months put the stock's forward P/E at just above 10.

    Matt

  • Report this Comment On February 16, 2011, at 11:53 PM, Merton123 wrote:

    Matt & I first screen is dividends. Lets take Altria, Intel and lockheed martin. The three pay high dividends. Altria used to be a Dow 30 component and Intel right now is a Dow 30 component. Lockheed Martin has been finding its way into several well known value manager's portfolio's (e.g., Tweedy Browne). Altria 6% dividend is the same as a bond coupon rate. Altria's problems related to ongoing litigation about its products causing health problems. Intel is interesting - can they leapfrog over their competitors superior computer chip? If the answer is yes - we are probably looking at doubling the share price. Lockheed Martin long term growth depends on its ability to move away from military and find customers elsewhere. Of the three choices I believe that Lockheed Martin has the probability of becoming a growth stock. I have already invested my 2011 Roth contribution so can only comment and put Lockheed Martin in my CAAP to overperform in the next five years.

  • Report this Comment On February 17, 2011, at 1:03 AM, TMFKopp wrote:

    @pryan37bb

    "I've been holding Altria since May of last year, it hasn't been stellar, returning about 16% including dividends (not reinvested)."

    I understand that with the market surging, 16% will be topped by many stocks, but I have to point out that for less than a year, a 16% return is nothing to sneeze at. And Altria was able to crank out that performance even though it didn't take nearly the paddling that most stocks did in 2009.

    Matt

  • Report this Comment On February 17, 2011, at 1:02 PM, Pat4Ra wrote:

    Matt,

    Concerning RRD which has current PE of +30 (MF chart) the required earnings growth could be steep to bring PE down to 10. And the stock price appreciation could be modest. Where do you the stock price in a years time? Thx, Pat

  • Report this Comment On February 17, 2011, at 1:27 PM, mderelus wrote:

    hello how is everyone doing ? i am very new and unexperience in this i just open an account in tradeking and i am looking to invest $1000 in the market but i really dont know which stock i should invest in i dont plan on doing anything with the money for 5yrs. please help any input is welcome thank you.

  • Report this Comment On February 17, 2011, at 3:33 PM, TMFKopp wrote:

    @Pat4Ra

    Scroll up to my response to Bonefish100, who had a similar issue with RRD. In short, the trailing P/E of 30 is misleading.

    As for: "Where do you the stock price in a years time?"

    I typically focus on a longer timeframe for my investments, generally five years at a minimum.

    Matt

  • Report this Comment On February 17, 2011, at 3:38 PM, TMFKopp wrote:

    @mderelus

    You've come to the right place. Keep reading and learning!

    Be aware that any stock ideas that other people give you can be a good starting point for picking an investment, but you should always do your own research so that you understand the investment and know what would compel you to keep holding, sell, or buy more.

    I've been writing a series aimed at beginning investors that could be helpful to you. Here is the most recent column:

    http://www.fool.com/investing/beginning/2011/02/14/the-easie...

    And if you scroll to the bottom of that article you'll find links to the other articles in the series.

    Matt

  • Report this Comment On February 17, 2011, at 4:25 PM, Merton123 wrote:

    mdreles - I recommend investing your money in a mutual fund versus buying an individual stock for $1,000. A mutual fund provides diversification and professional management for a small fee. I personally invest most of my money that is in taxable accounts in various index funds at Vanguard. The money that I invest in Vanguard Brokerage Roth IRA account is invested in actively managed mutual funds like Motley Fools Independence Fund because I don't have to worry about capital gains tax eating away at my return. Motley Fool has the CAPs community where you can create a stock watchlist and find out if you are capable of buying stocks consistently that outperform the Standard & Poor 500 index. The majority of people find out that the index is a tough boogie to beat and stick with mutual funds after trying their stock picking powess in the CAPs community.

  • Report this Comment On February 17, 2011, at 7:24 PM, mderelus wrote:

    thank you that is very usefull

  • Report this Comment On February 18, 2011, at 1:18 AM, TMFKopp wrote:

    @mderelus

    I want to highlight one part of what Merton123 said: investing on paper.

    Whether it's CAPS (which I love -- caps.fool.com) or some other service, you can, as Merton points out, test your mettle and learn without risking a dime. Once you've learned a good bit and feel comfortable finding your way around the investment world, then you can put real money into the equation.

    Now I will highlight that *I'm talking about me personally here*, but when I started investing I found that investing on paper didn't drive me to do a whole lot of work. Since nothing was at risk, I did fairly minimal work.

    I then ended up with an inheritance in my lap and the suggestion that I should put it in an IRA and invest it... whoa! Suddenly having real money in the picture got me focused *fast*. I read more books, started digging into SEC filings, etc etc.

    So for me at least having some money at stake drove me to work harder and learn more. I don't think it would need to be much money to drive me (I *hate* losing money), just something.

    Anyway, hope this helps-

    Matt

  • Report this Comment On February 18, 2011, at 12:59 PM, mderelus wrote:

    ok will look into that this is very helpful

  • Report this Comment On February 19, 2011, at 10:41 PM, longertime01 wrote:

    Altria means "get high". It's a fun stock to own. Every time I see a person smokes, the moat gets wider. It certainly is a new way looking at smoking, ha ha.

  • Report this Comment On February 19, 2011, at 10:52 PM, longertime01 wrote:

    I don't smoke but am addictive to MO.

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