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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 based on them. Strong margins ensure that a 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%||3.3%||Fail|
|1-Year Revenue Growth > 12%||(3.2%)||Fail|
|Margins||Gross Margin > 35%||10.9%||Fail|
|Net Margin > 15%||6.3%||Fail|
|Balance Sheet||Debt to Equity < 50%||60.5%||Fail|
|Current Ratio > 1.3||1.89||Pass|
|Opportunities||Return on Equity > 15%||14.0%||Fail|
|Valuation||Normalized P/E < 20||8.30||Pass|
|Dividends||Current Yield > 2%||2.8%||Pass|
|5-Year Dividend Growth > 10%||17.9%||Pass|
|Total Score||4 out of 10|
Source: S&P Capital IQ. Total score = number of passes.
Since we looked at L-3 Communications last year, the company has kept its four-point score. But a loss of more than 10% in its stock over the past year has made the company look like an even bigger bargain.
There's no doubt that budget cuts at the Pentagon are having a big impact on defense-industry businesses. General Dynamics (NYSE: GD ) reported a 3% drop in revenue during the first quarter of 2012, due largely to its exposure to government orders, and prospects look equally troubling for Lockheed Martin (NYSE: LMT ) and Boeing (NYSE: BA,) in light of the possibility for even more defense cuts down the road.
But L-3 has some diversification across product lines that may eventually help wean it off its reliance on the U.S. military. With the company having spun off its Engility (NYSE: EGL ) government-services subsidiary earlier this week, L-3 is left with more emphasis on its electronic systems and C3ISR divisions, both of which have held up reasonably well, thanks to foreign orders and greater demand.
Still, the huge uncertainty over the defense budget is taking a toll on prospects for the industry. With the Presidential election later this year, few analysts expect any decisive action on the budget front until next year at the earliest. Until then, defense stocks co uld be stuck in limbo waiting for future guidance.
To improve, L-3's best bet would be to keep working on other customers beyond the U.S. government to try to protect itself from budget cuts. That's a tough assignment for any company, but if L-3 can pull it off, it could make it that much easier to reach for perfection in the years ahead.
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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