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, Hansen Natural, Home Depot, and Berkshire are some of the stock market's greatest successes. These companies have earned early investors fantastic 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, Hansen, Home Depot, or Berkshire before they were big names?
That's not to say that one stock will be a tech superstar, or be run by a superstar investor. Instead, Netflix, Hansen, Home Depot, and Berkshire all share a set of remarkable traits that characterized them when their amazing runs began. All were:
- Small.
- Led by dedicated founders or long-tenured CEOs.
- Fiscally conservative.
- Profiting from a wide market opportunity.
If the next stock that's pitched to you doesn't possess these traits, 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 $11 billion; Citrix at $7 billion.
Are they led by long-tenured leaders? One definitely is. Scott McNealy co-founded Sun in 1982, served as CEO from 1984 to 2006, and continues to sit as chairman. Though Citrix Systems CEO Mark Templeton has a long tenure with the company -- he's been with Citrix in some capacity since 1995 -- he left his post as CEO for a full year in 2000-2001 while the board searched (in vain) for new leadership. While he's done an admirable job, Templeton probably doesn't pass this test.
Are they fiscally conservative? Yes and no. While both companies have strong balance sheets and are generating free cash flow, capital expenditures at both companies are rising, and Citrix has seen margins decline in recent years.
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 -- as evidenced by the rising capex. Whatever gains they make will be hard-fought, and they 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 they could make for good investments going forward. However, I don't think either one has the core traits that made companies like Netflix, Hansen, Home Depot, and Berkshire such incredible investments -- the traits we seek in 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 or long-tenured CEOs.
- Fiscally conservative.
- Profiting from a wide market opportunity.
If you'd like to take a look at the companies we've found that meet those four criteria -- the companies that have put our service 25 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 Berkshire Hathaway. The Motley Fool owns class B shares of Berkshire Hathaway. Berkshire and Netflix are Stock Advisor recommendations. Berkshire and Home Depot are Inside Value picks. The Fool's disclosure policy assures you that no stocks were harmed in the penning of this article.
