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 Telefonica (NYSE: TEF ) 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 Telefonica.
What We Want to See
Pass or Fail?
|Growth||5-Year Annual Revenue Growth > 15%||3.9%||Fail|
|1-Year Revenue Growth > 12%||(6.5%)||Fail|
|Margins||Gross Margin > 35%||52.4%||Pass|
|Net Margin > 15%||6.7%||Fail|
|Balance Sheet||Debt to Equity < 50%||264.1%||Fail|
|Current Ratio > 1.3||0.62||Fail|
|Opportunities||Return on Equity > 15%||15.1%||Pass|
|Valuation||Normalized P/E < 20||30.74||Fail|
|Dividends||Current Yield > 2%||11.3%*||Pass|
|5-Year Dividend Growth > 10%||13.7%||Pass|
|Total Score||4 out of 10|
Source: S&P Capital IQ. Total score = number of passes. *Trailing yield.
Since we looked at Telefonica last year, the company has dropped two points. A big jump in its valuation and a substantial decline in net margins have weighed on the stock's score.
Throughout 2011, Telefonica suffered from its proximity to Europe's sovereign debt crisis, alongside several other telecom providers on the Continent. France Telecom (NYSE: FTE ) also saw its shares plunge and its dividend yield soar in 2011, as it now contemplates selling off its Swiss subsidiary for $2.1 billion. Similarly, Portugal Telecom (NYSE: PT ) continues to impress investors with its huge dividend yield.
What could help Telefonica survive is its exposure to emerging markets. Like Portugal Telecom, Telefonica has exposure to Brazil and other locations in Latin America. With 43% of its revenue coming from outside the eurozone, Telefonica's eventual success won't be tied to Europe's fate.
Telefonica recently announced that it would cut its dividend in 2012, with only a portion of the payment coming in cash. However, conserving cash can be a smart move during tough times, and if it enables the company to restructure more efficiently, it could pay off for Telefonica shareholders in the long run.
For Telefonica to get closer to perfection, a Spanish economic revival would be incredibly helpful. Although Banco Santander (NYSE: STD ) and the economically sensitive banking sector are particularly vulnerable to a bad resolution to the sovereign debt crisis, Telefonica could actually survive if its focus on international diversification bears fruit.
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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