The One Stock You Must Buy

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Stop me if you've heard this one. The one stock you must buy is ... the next EchoStar Communications (Nasdaq: DISH), Infosys Technologies (Nasdaq: INFY), and Charles Schwab (Nasdaq: SCHW) all rolled into one.

That's a pitch I'm sure you've heard some semblance of at cocktail parties, golf outings, and weddings, and, of course, on the Internet.

And it's a pretty appealing pitch. After all, EchoStar, Infosys, and Schwab 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 EchoStar, Infosys, or Schwab before they were big names?

That's not to say that one stock will be a tech superstar or an emerging markets play. Rather, EchoStar, Infosys, and Schwab all share a set of remarkable traits that characterized them when their amazing runs began. All were:

1. Small.
2. Led by dedicated founders.
3. Fiscally conservative.
4. 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 Heelys (Nasdaq: HLYS) and Crocs (Nasdaq: CROX) -- two footwear plays that have recently been pitched to me at cocktail parties, golf outings, weddings, and of course, on the Internet.

Are they small? Yes and no. Heelys is capitalized at $175 million (though it used to be much more); Crocs at $2.5 billion.

Are they led by dedicated founders? Neither company's founder continues to lead the company, but both have founders who remain involved. Roger Adams, for example, founded Heelys in 2000. He continues to serve as its director of research and development. And George Boedecker, who co-founded Crocs, is still the largest shareholder -- even after his resignation from the board in 2006.

Are they fiscally conservative? Both companies have had success with their products, with booming sales and income and solid balance sheets, but Heelys has seen accounts receivable (AR) rise and inventories accumulate -- an indication that demand may be waning. Crocs has also seen an enormous increase in AR and inventories.

Do they have wide market opportunities? It gets a little cloudy here. While both companies have products that have received rave reviews, any investing thesis depends on being able to predict whether the brands are fads or if they can expand and have staying power. The recent decline in both stocks is a warning about what can happen when a market dries up.

The Foolish final word
I'm not here to be negative about either Heelys or Crocs. Both have positive traits and could make for good investments going forward. I don't, however, think either one has the collection of traits that made companies like EchoStar, Infosys, and Schwab such incredible long-term 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:

1. Small.
2. Led by dedicated founders.
3. Fiscally conservative.
4. 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 more than 16 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. Schwab is a Stock Advisor recommendation. The Fool's disclosure policy assures you that no stocks were harmed in the penning of this article.