Hunting for Buried Treasures

I've finally managed to accrue enough disposable income to put it in the stock market, and I've decided to try finding a candidate not just for my own portfolio, but also for the Motley Fool Hidden Gems newsletter. I'm going to sift through a number of candidates with the goal of formally recommending a selection to my bosses. After all, I've been writing for them for nine months. I think I've earned the right to be listened to. Hmm, maybe I should ask for a raise instead? Nah .

Although there are no formal criteria set up for selecting a hidden gem, I've cobbled together a few of my own, as well as outright stolen some of my colleagues'. One thing to remember, though: This isn't intended as a checklist. Whether a stock fits any of these criteria does not make it a Hidden Gems candidate, a good investment, or a bad investment. This is just my own set of criteria. Your criteria can -- and should -- vary.

With that said, here they are:

1. Market capitalization of less than $2.5 billion
A Hidden Gems candidate has to be a small company. It is likely to have a lot more room to grow, and the potential for hefty returns should thus be good. This doesn't mean that a business can't have a larger market cap. It's just that the bigger the company is, the more likely it becomes that quite a few investors have probably already uncovered it. I prefer something so small that it simply flies under most people's (including analysts') radar.

2. An intriguing business
This is the most personal of the criteria. I've learned that I have an entrepreneurial mind and can sniff out intriguing ideas. (Of course, I'm also a screenwriter, so I know a good idea when I hear one.) This generally means selling a specific product to a small but growing niche of the population, filling a need that nobody's taken on yet, or doing something regarded as distasteful. For example, if I could invest directly in an online poker site, I'd do it. Pawnshops are another example, provided conditions are right. Hidden Gems holding Coinstar (Nasdaq: CSTR  ) is another.

3. Net earnings growth of 15% annually, with the same projected over the next five years
As an investor, you hope that a small company is not only valued cheaply but also growing strongly. It's not necessary for the company to have been burning off the barn doors before this year, but I do want to see 15% growth two years running.

4. A generator of positive free cash flow
We all know that free cash flow is what a business is all about. A company needs it to grow, pay down debt, pay dividends, snap up other businesses, or just stash away in case the business climate changes and a need to adjust strategy arises.

5. A market cap-to-free cash flow ratio less than the P/E ratio
Just because a company has FCF, that doesn't mean it's priced cheaply enough for seekers of hidden gems. This metric allows us to see how much free cash a company is generating in relation to its size, as MC/FCF is essentially the cash equivalent of P/E. Thus, if MC/FCF is less than P/E, that indicates more cash than accrual earnings per share, and it bodes well for a company's future liquidity levels.

6. Market cap-to-free cash flow-to-five-year growth rate of less than 0.66
You can think of this as the five-year PEG, but using the MC/FCF ratio instead. The lower this ratio is, the better. A low ratio means the company is growing at a fast clip and pumping out the moolah. With a PEG of less than 1, the company is selling at a discount to growth expectations. An MC/FCF/five-year PEG of less than 0.66 offers some margin of safety in the event that the company doesn't measure up to growth expectations.

7. A reasonable level of debt
Reasonable? Huh? Look, ideally, I want to see a company with all cash and no debt. But there are some situations in which debt is a good thing, or at least acceptable. If a company is using its debt wisely -- to expand, for example -- that's fine. The important thing is that (a) the company is generating enough FCF to at least cover interest payments and (b) debt is no more than 20% of equity. Or, if a company owns a lot of real estate and has decent mortgage rates, that's perfectly acceptable, too. Hey, if a company can get a credit facility at 6% and its net profit margins are at 10%, then more power to it. Heck, if a credit card company offers me a balance-transfer deal of 1.99% APR until I pay off the balance, I'll max the thing out. That means I can take that cash and invest it somewhere else (uh . not that I'd recommend that).

8. Net profit margins of 7%
Keeping one penny on the dollar doesn't give you much wiggle room. You've gotta keep the money you make, or you go under. Simple as that.

9. Insider ownership of 20%-50%
I searched for a plumber by going through the yellow pages and finding someone who was not part of a big company . or even a small one. I wanted Steve Plumber who's been on his own for 30 years. I wanted Steve because I knew he would do what was best for his customer in order to earn his repeat business. He would also take careful interest in his own bottom line. I want the same thing with a public company. I want insiders to think their own company is the best place to park their investment dollars. Bad example: Bally Total Fitness (NYSE: BFT  ) , where insiders own 2.81% of their stock. And -- what a shock -- that company has demonstrated repeated contempt for its shareholders and customers. Good example: Middleby (Nasdaq: MIDD  ) , with 55% insider ownership.

We don't want insiders owning too much, though. Then they wield too much control over what the company does, and if they start to dump shares, the little investor may get caught holding the bag.

10. Shareholder dilution of less than 3%
What good is a company if the money it makes is worth less and less each year? The point is, we do not want executives to cash in tons of stock options and dilute our earnings. Nor do we want secondary filings unless there's a really, really good reason for it. In fact, I'd love to see a company buy back so much stock that there are fewer shares outstanding year after year, provided that those shares are purchased when they are undervalued. The term "undervalued" should mean the price the stock is at or close to at the time of my evaluation. If I've found a hidden gem, management may think that it has as well. If, by this point, my first nine metrics have failed -- well, buybacks become irrelevant. The 3% number is somewhat arbitrary. If a company is consistently growing earnings at 35% annually, I won't quibble if dilution is a bit higher. Likewise, a company growing at only 15% had better be at 3% dilution or less.

To all of these metrics, I add three other factors. First, is the PEG ratio less than 1? A fair valuation is 1, so a PEG lower than that generally indicates that the stock is probably undervalued. Does a mutual fund manager I respect hold the stock? This isn't a deal-breaker, but it's nice to know that somebody I admire sees the same opportunity I do. Finally, does it all just feel right? After looking at everything, does the company in the gestalt give me any reason to pause?

So that's my criteria. Watch this space as I try to find a hidden gem.

Want to read more about hidden gems? Check out:

Even though Fool contributor Lawrence Meyers is on the hunt for a stock, he does not own any of the stocks mentioned in this article. The Motley Fool is investors writing for investors.


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