5 Traits of Great Stocks

A 2009 study revealed that, in aggregate, three of four stocks on the U.S. markets lost value between 1980 and 2008, despite the S&P 500 returning 10.4% annualized. What this means is the winning stocks won big, thereby compensating for the overwhelming number of losing stocks. However, if you hope to be invested in the winners, you need to choose carefully.

More than two decades of investing experience has helped us at Motley Fool Pro zero in on what makes for a winning business. Here are five of the key traits we seek in each stock before we buy it.

1. Sustainable competitive advantage
Healthy profits in a business attract competition -- everyone wants a piece of the profit pie. The only way a company can maintain profit margins and grow is to have a sustainable competitive advantage that serves as a protective moat around the business.

You hear this quality talked about often, from Warren Buffett on down, but many investors still fail to buy companies that sustainably meet the bill. That's because it's the rare company that truly has lasting advantages -- but they are out there.

They're usually midsized or larger ($5 billion and up), have a long history of steady growth, and own assets or market share that provide enduring advantages over all others in the field or that may enter it.

Think Rio Tinto (NYSE: RTP), one of the largest commodity mining operations on the planet (the world isn't producing more minerals anytime soon); or Laboratory Corp. (NYSE: LH  ) , which enjoys relationships it has developed with clients since 1971, and has more than 1,600 patient service centers in convenient locations.

Yahoo! (Nasdaq: YHOO  ) has some sustainable competitive advantages, but it hasn't evolved quickly enough to keep all of its customers happy. However, network effects and market share -- competitive advantages -- are buying it time to right the ship.

2. Diverse customer base
A competitive advantage isn't worth much if the business  depends on only a few customers. We like our businesses to have widely diverse and growing customer bases. This way, when some customers are lost, the business is not in peril and will continue to grow. We shy away from buying companies where just one or two customers account for 5% -- or more -- of annual sales, even if the primary customer is the government, for example.

3. Pricing power
With a lasting competitive edge and a broad customer base, a company usually enjoys some degree of pricing power. When costs rise, the company can pass them on to customers rather than suffering them itself. The strongest companies can implement modest price increases every few years without losing or alienating customers. Pricing power gives a company one more important arrow in its quiver as it hunts for long-term annualized growth.

When Procter & Gamble (NYSE: PG  ) ticks up the price on some products by a dime, do customers defect? Most don't, because they're buying a brand they favor and the additional cost is small for them, but in aggregate, strong for P&G.

4. Significant recurring revenue
If a business enjoys our first three criteria and also has significant recurring revenue, we become even more interested. By recurring revenue, we mean sales that repeat all but automatically, often with the same customers again and again, and usually without the company needing to spend more on marketing or reinventing itself or its products.

A majority of revenue at Oracle (Nasdaq: ORCL  ) recurs whenever a customer renews a software license, which typically happens annually. Elsewhere, insurance companies enjoy recurring revenue every time a policy is auto-renewed, which happens more than 80% of the time at the best providers. More and more companies are getting wise to "annuitized" revenue, and selling annual subscriptions to their wares or services.

As General Motors collapsed in the first major recession in years, we're reminded that automakers are an example of anything but easy recurring revenue. They need to advertise continually to drive each sale, making for an expensive business that's vulnerable when the economy stumbles.

Easily or "naturally" recurring revenue results in more predictable and more profitable results, and helps maintain a business even during recessions. Some of the stocks we buy in Pro won't have naturally recurring revenue, but when it drives at least 30% of annual sales, the company gets a close second look from us. Companies with 80% to 90% recurring revenue and a growing market get an extremely close look.

5. Expanding free cash flow
The qualities we've mentioned so far will usually lead to strong free cash flow, which is the lifeblood of any company. By definition, free cash flow is cash from operations minus capital spending and any other nonoperational cash income, such as tax benefits from stock options. Much more reliable than mere earnings-per- share numbers, we're generally looking for free cash flow that's growing at least 8% to 10% annualized over the long term.

No company grows in a straight line, but over time we want expanding free cash flow to drive the value of the businesses we own. Strong free cash flow growers over recent years include Gilead Sciences (Nasdaq: GILD  ) and credit card giant Visa (NYSE: V  ) . Meanwhile, a rebound in free cash flow can revitalize a company, as has happened with Open Text (Nasdaq: OTEX  ) the last handful of years, more than doubling its share price. All three companies, incidentally, also enjoy many of the four traits above.

If you'd like to know the other key traits we demand in Motley Fool Pro, and see what we're buying now, you have a chance to take a look for a few days this month. To keep membership manageable, Motley Fool Pro hasn't opened to new members since June of 2009, and we don't know when it will happen again after this week. So, come on in while you can, and see what the fuss is all about -- just enter your email in the box below to learn more.

Jeff Fischer is advisor to Motley Fool Pro and Motley Fool Options. He owns shares of Apple, Google and Oracle. Open Text is a Motley Fool Rule Breakers recommendation. Laboratory Corp. of America Holdings is a Stock Advisor pick. Procter & Gamble is an Income Investor pick. Motley Fool Options has recommended writing puts position on Open Text. The Fool owns shares of Oracle and Procter & Gamble. The Fool has a disclosure policy.

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Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On January 24, 2010, at 12:18 AM, henryking54 wrote:

    <<However, if you hope to be invested in the winners, you need to choose carefully.>>

    Mr. Fischer obviously failed to understand the conclusion of the Money Magazine article he refers to in the first sentence of his article. The conclusion of the article is not, as Mr. Fischer claims, that you need to choose stocks carefully. In fact, the conclusion of the article is the exact opposite: you should buy index funds because it is impossible to know which stocks will be the winners beforehand:

    "If a small list of securities accounts for the market's long-term returns, why not avoid all the headaches and losses you've suffered recently by carefully choosing these superstocks?

    Simple: Because a portfolio of "carefully chosen" equities could easily wind up with none of the best-performing stocks in the market - and thus produce flat or negative returns over many years. Missing out on even a handful of superstocks can leave you short of your target."

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