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 Arena Pharmaceuticals (Nasdaq: ARNA ) 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 Arena Pharmaceuticals.
What We Want to See
Pass or Fail?
|Growth||5-Year Annual Revenue Growth > 15%||(14.3%)||Fail|
|1-Year Revenue Growth > 12%||(4.1%)||Fail|
|Margins||Gross Margin > 35%||43.2%||Pass|
|Net Margin > 15%||NM||NM|
|Balance Sheet||Debt to Equity < 50%||266.1%||Fail|
|Current Ratio > 1.3||4.48||Pass|
|Opportunities||Return on Equity > 15%||(161.6%)||Fail|
|Valuation||Normalized P/E < 20||NM||NM|
|Dividends||Current Yield > 2%||0%||Fail|
|5-Year Dividend Growth > 10%||0%||Fail|
|Total Score||2 out of 8|
Source: S&P Capital IQ. NM = not meaningful because of substantial negative income and negligible revenue. Total score = number of passes.
Since we looked at Arena Pharmaceuticals last year, the company has lost a point. Revenue has fallen back during 2011, and debt-to-equity levels have soared.
Arena's hopes rest largely on its obesity drug, lorcaserin. But that's been a terrible niche to try to gain FDA approval. The FDA vetoed an earlier 11-8 panel recommendation, choosing not to approve Orexigen's (Nasdaq: OREX ) Contrave and instead requiring a trial to measure heart-related problems from taking the drug. In mid-2010, VIVUS (Nasdaq: VVUS ) didn't even get that far with its Qnexa drug; the FDA panel recommended that the drug not get approval. And even worse, the FDA took an existing drug off the market: Abbott Labs' (NYSE: ABT ) Meridia, which also raised heart concerns.
Still, last week, Arena announced that it had resubmitted its marketing application for lorcaserin to the FDA. It's unclear what the FDA will decide, but some shareholders are already getting in on the betting by bidding up the stock somewhat.
For Arena to get closer to perfection, it clearly needs to get lorcaserin past the FDA. Otherwise, it's likely to run out of cash without much prospect for getting anything else through its pipeline fast enough. On the other hand, an approval could make Arena seem perfect -- at least in hindsight.
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."