Stop me if you've heard this one. The one stock you must buy is ... the next Costco
That's a pitch I'm sure you've heard some semblance of at cocktail parties, golf outings, weddings, and, of course, on the Internet.
And it's a pretty appealing pitch. After all, Costco, Ameritrade, Yahoo!, and Intuit are some of the stock market's great success stories. These companies have earned early investors mind-boggling returns over short and long periods of time.
The secrets of success
So the question is: Does that one stock you must buy exist? Of course it does. But can you find it? That's a different matter.
Here, however, is a litmus test to gauge every stock tip you come across. Simply ask: Does this company bear any resemblance at all to Costco, Ameritrade, Yahoo!, and Intuit before they were big names?
That's not to say that one stock will be a big box store or a tech superstar. Rather, Costco, Ameritrade, Yahoo!, and Intuit all share a set of remarkable traits that characterized them when their amazing runs began. All were:
- Small.
- Led by a dedicated founder(s).
- Fiscally conservative.
- Profiting from a wide market opportunity.
If the next stock that's pitched to you doesn't possess these traits, then you're probably better off passing.
A case study
Consider, for example, the cases of Emdeon
Are they small? Not really. Both companies are capitalized at more than $2 billion.
Are they led by dedicated founders? It wouldn't seem so. Neither company has a high (greater than 10%) level of insider ownership, and neither CEO has been on the job for more than a few years.
Are they fiscally conservative? Both companies look like strong operators given their recent success, and both have improved their metrics over the past few years. That said, each has a slug of debt on its balance sheet.
Do they have wide market opportunities? It gets a little cloudy here. While both companies have products that have received good reviews, both face significant competition going forward.
The Foolish final word
I'm not here to be negative about either Emdeon or Tempur-Pedic. Both have positive traits and could make for good investments going forward. I don't, however, think either one has the perfect storm of traits that made companies like Costco, Ameritrade, Yahoo!, and Intuit such incredible investments and that we look for at our Motley Fool Hidden Gems small-cap investing service.
Again, we believe that tomorrow's big winners will start off:
- Small.
- Led by a dedicated founder(s).
- Fiscally conservative.
- Profiting from a wide market opportunity.
If you'd like to take a look at the companies we've found that meet the four criteria mentioned above and have put our service 32 percentage points ahead of the S&P 500 since 2003, click here to join Hidden Gems free for 30 days.
This article was originally published on Oct. 19, 2006. It has been updated.
Tim Hanson does not own shares of any company mentioned. Costco and Yahoo! are Stock Advisor recommendations. The Fool's disclosure policy assures you that no stocks were harmed in the penning of this article.
