To close out each year, we Motley Fools scavenge the public markets searching for the greatest common stocks for you in the year and years ahead. No investment banking arm tells our analysts what they can and can't say. And we don't change our ratings on a stock every month to help a sales force of brokers get their clients to transact!
Our sole aim each year -- as you'll see in this year's Stocks 2005 -- is to find sound companies at magnificent prices. I know that's your aim as an investor, too.
Beating the Street
The benefits of this sort of independent research and rigorous discipline drove our cadre of analysts last year to earn our readers 37% gains vs. S&P 500 returns of 12%. Over the past three years, we haven't picked all winners. No chance. But our year-end stock selections have rung up rewards of 24.1% per year vs. the market's return of 8.9%. In Stocks 2005, we're again hanging our caps on a dozen different stocks running the gamut from classic value to growth, from true leaders to turnarounds.
To find them, we've used the principles of master investors like Peter Lynch, Benjamin Graham, Seth Klarman, Jim Gipson, Shelby Davis Sr., and Martin Whitman. I believe in crediting mentors, so you should know it was their investment teaching that led me to victory in last year's publication. My formal profile of DHB Industries (AMEX: DHB ) , the maker of world-class body armor for the military and law enforcement, has risen 190% since last November.
In this article, I want to explain how I found the company and why I felt it would outperform. I used these very same sorts of principles in the just-released Stocks 2005 to locate a dividend-paying small company that makes GPS systems products. I believe it will very substantially beat the market over the next 1-5 years, with the potential to be a Peter Lynch multibagger.
But first, here's how I found last year's winner.
So, how did I do it?
What follows are six factors that persuaded me to profile DHB Industries. For any given stock in my work in Hidden Gems, I'll consider up to 70 different elements of the business, market opportunity, management team, competitive set, and valuation before forming firm conclusions. All 70 factors are not equal. But the six I'm sharing today are foundational precepts of my approach to micro-, small-, and mid-cap investing.
But first, you need to know that DHB Industries didn't soar effortlessly to new highs in 2004. Three months after my profile, the stock was down 30% on news that CEO David Brooks, the company's largest shareholder, had sold more than a million shares of the stock. Investors panicked.
That sort of overreaction leading to high price volatility is inevitable in small-cap stock investing. After all, the 40% rise or fall in the value of a small cap is equivalent to a 2-cent move in shares of Microsoft (Nasdaq: MSFT ) . The software giant is valued at more than $290 billion today, while DHB Industries was valued below $300 million when I profiled it. The smaller the business, the more volatile its stock. And that volatility can slaughter speculators while it deepens the pockets of investing owners.
Be an owner with us at The Motley Fool, and you'll want to look for these six signs of a great small-cap stock:
1. Positive owner earnings. The first thing I look for in a small business is that it generates positive free cash flow for its outside owners. Is the company truly profitable? Since earnings can be manipulated in standard accounting, I focus on cash flows, or owner earnings (as defined in Hidden Gems). DHB had about $15 million in owner earnings heading into last year.
2. Accelerating sales and improved operating margins. The company closed out fiscal 2003 riding new military contracts to extraordinary sales gains. The firm matched that top-line growth with improvements in its operating profitability. When you find accelerating sales growth alongside improving margins, take note.
3. A cheap valuation. How can you find a growth company with improving margins that's priced cheaply? Look for minor blemishes. In the case of DHB, its CEO's decade-old legal settlement for insider trading kept institutional owners on the sidelines. Further, the overrated threat of disruptive union actions inside the company pushed the share price lower still. Finish it off with the CEO selling some shares, and you have the temporary panic that took DHB Industries down to $5 per share last winter before its rise to $20 today. Look for taints and fixable problems. They can make bargains out of well-run companies.
4. High insider ownership. It's not a fluke that firms like Wal-Mart (NYSE: WMT ) , Amazon.com (Nasdaq: AMZN ) , Berkshire Hathaway (NYSE: BRK.A ) , and Johnson & Johnson (NYSE: JNJ ) have turned into multibillion-dollar companies run by strong insider and family ownership. Their stocks rose hundreds or thousands of times in value because they had a major enticement to reward outside shareholders. As the largest common stockholders, they stood to benefit the most! At DHB, the Brooks family owns a massive amount of this stock. Their incentive is to increase the firm's commercial value, compounding returns for themselves (and, by extension, us).
5. Management effectiveness. As so many investing masters have, I look for high rates of return on assets, equity, and invested capital. And I like to see these numbers on the upswing. Check DHB's management ratios, with returns on assets above 20%. They're simply outstanding and improving. This is a management team that knows how to prudently allocate its capital.
6. A great product. Believe it or not, this is one of the later steps I take as an investor. Each of the five factors above is highly quantitative. Only when I see an impressive business do I ask myself, "So, how great is its product?" That ordering helps me avoid a company like Krispy Kreme (NYSE: KKD ) , with irresistible doughnuts but arguably incompetent management and a very questionable approach to franchising. But when I've found a family-run business I love, it is pure bliss to uncover world-class products fueling the growth. DHB's Interceptor body armor is consistently rated the best by all four branches of the military and by law enforcement officials. It has protected countless Americans in the line of duty.
What you can do now
Not every great investment that you or I find is going to demonstrate these principles. That said, I wanted to share six things I look for in promising small caps. I'm optimistic about my Stocks 2005 pick but thankful to be surrounded by first-rate analysts and great investors like you in the Internet community. Working together without Wall Street's embedded conflicts of interest, we'll find some marvelous investments in the year ahead.