Has KKR Financial Become the Perfect Stock?

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 KKR Financial (NYSE: KFN) 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 KKR Financial.

Source: S&P Capital IQ. Total score = number of passes.

Since we looked at KKR Financial last year, the company has given back not only the point it earned from 2010 to 2011, but another point on top of that, as revenue has fallen over the past year. Yet shares of the high-yielding company have managed to pick up about 25% over the past year.

KKR Financial is a specialty finance company that acts as a holding company for subsidiaries that are real estate investment trusts. Because of KKR Financial's structure as a partnership, its distributions are governed by partnership tax law, which can lead to favorable treatment of some of the money shareholders receive as nontaxable return of capital rather than dividend or ordinary income.

The company's primary business is to buy collateralized loan obligations. Using a leveraged model that's similar to what mortgage REITs Annaly Capital (NLY 0.59%), American Capital Agency (AGNC -1.28%), and Chimera Investment (CIM -0.24%) use to invest in mortgage-backed securities, KKR Financial profits from spreads between the income it receives from its investments and the interest expense it pays to borrow money.

Because the Fed plans to keep interest rates low at least until 2015, KKR Financial has plenty of time to keep benefiting from current favorable conditions. Yet it has also taken steps to lock in longer-term financing, having issued exchange-traded bonds under a separate KKR Financial (NYSE: KFI) ticker symbol.

For KKR Financial to improve, it needs to try to keep interest spreads up while also minimizing loan losses. Over time, though, gains on investment sales, which also fall into revenue, will have to peter out, representing a continuing headwind for the company and potentially keeping it from perfection in the future.

Keep searching
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.

Click here to add KKR Financial to My Watchlist, which can find all of our Foolish analysis on it and all your other stocks.