Stop me if you've heard this one. The one stock you must buy is ... the next Netflix
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, Netflix, Whole Foods, Chico's, and Berkshire 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 Netflix, Whole Foods, Chico's, or Berkshire before they were big names?
That's not to say that one stock will be a tech superstar or run by a superstar investor. Rather, Netflix, Whole Foods, Chico's, and Berkshire all share a set of remarkable traits that characterized them when their amazing runs began. All were:
- Small.
- Led by dedicated founders.
- 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 Sun Microsystems
Are they small? No. Sun is capitalized at $19.2 billion; Citrix at $6.3 billion.
Are they led by dedicated founders? One is. Scott McNealy founded Sun in 1982, served as CEO from 1984 to 2006, and continues to sit as chairman. Citrix Systems CEO Mark Templeton has only been with the company since 1998.
Are they fiscally conservative? Yes and no. While both companies have strong balance sheets, only Citrix Systems is generating profits and substantial free cash flow relative to its market cap.
Do they have wide market opportunities? It gets a little cloudy here. While both companies have solid products and opportunities to grab greater market share, they both operate in extremely competitive industries. Whatever gains they make will be hard fought and may not last.
The Foolish final word
I'm not here to be negative about either Sun or Citrix Systems. Both have positive traits and could make for good investments going forward. I don't, however, think either one has the core traits that made companies like Netflix, Whole Foods, Chico's, and Berkshire 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 dedicated founders.
- 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 27 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 owns shares of Whole Foods and Berkshire Hathaway. Whole Foods and Netflix are Stock Advisor recommendations. Berkshire Hathaway is an Inside Value and Stock Advisor pick. The Fool's disclosure policy assures you that no stocks were harmed in the penning of this article.
