Every investor would love to stumble upon the perfect stock. But will you ever really find a stock that provides everything you could possibly want?
One thing's for sure: You'll never discover truly great investments unless you actively look for them. Let's discuss the ideal qualities of a perfect stock, then decide if L-3 Communications (NYSE: LLL ) fits the bill.
The quest for perfection
Stocks that look great based on one factor may prove horrible elsewhere, making due diligence a crucial part of your investing research. The best stocks excel in many different areas, including these important factors:
- 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 mean nothing if a company can't produce profits from them. Strong margins ensure that company can turn revenue into profit.
- Balance sheet. At debt-laden companies, banks and bondholders compete with shareholders for management's attention. Companies with strong balance sheets don't have to worry about the distraction of debt.
- Money-making opportunities. Return on equity helps measure how well a company is finding opportunities to turn its resources into profitable business endeavors.
- Valuation. You can't afford to pay too much for even the best companies. By using normalized figures, you can see how a stock's simple earnings multiple fits into a longer-term context.
- Dividends. For tangible proof of profits, a check to shareholders every three months can't be beat. 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 L-3 Communications.
What We Want to See
Pass or Fail?
|Growth||5-Year Annual Revenue Growth > 15%||8.6%||Fail|
|1-Year Revenue Growth > 12%||0.3%||Fail|
|Margins||Gross Margin > 35%||12.2%||Fail|
|Net Margin > 15%||6.0%||Fail|
|Balance Sheet||Debt to Equity < 50%||59.7%||Fail|
|Current Ratio > 1.3||1.86||Pass|
|Opportunities||Return on Equity > 15%||13.9%||Fail|
|Valuation||Normalized P/E < 20||9.68||Pass|
|Dividends||Current Yield > 2%||2.3%||Pass|
|5-Year Dividend Growth > 10%||24.0%||Pass|
|Total Score||4 out of 10|
Source: Capital IQ, a division of Standard and Poor's. Total score = number of passes.
With just four points, L-3 Communications hasn't treated shareholders very well. The entire industry has faced tough times and an uncertain future, but at L-3's current valuation, value investors are starting to take notice.
Investors are clearly worried about the current impasse in Washington and the inevitable budget cuts that will result from big fiscal deficits. Those worries have kept a lid on defense stocks, with Northrop Grumman (NYSE: NOC ) and Alliant Techsystems (NYSE: ATK ) joining L-3 with trailing P/Es below 10. And given that L-3 gets more than 75% of its business directly from the U.S. military, it could see a much bigger hit than some of its peers.
But L-3 has some positives. Along with Boeing (NYSE: BA ) and Lockheed Martin (NYSE: LMT ) , L-3 stands out for its rising backlogs over the past year. More importantly, as fellow Fool contributor Andrew Tonner recently pointed out, L-3's specialization in unmanned aircraft and cybersecurity could give it a better chance to survive budget cuts.
The debt ceiling debate could well serve as a catalyst for L-3 and other defense stocks going forward. At this point, any clarity on the future of defense spending would help these companies. So while L-3 isn't perfectly positioned right now, its compelling value proposition could get even better in the near future.
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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Finding the perfect stock is only one piece of a successful investment strategy. Get the big picture by taking a look at our "13 Steps to Investing Foolishly."