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 Costco (Nasdaq: COST), TD Ameritrade (Nasdaq: AMTD), Yahoo! (Nasdaq: YHOO), and Intuit (Nasdaq: INTU), all rolled into one.

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 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:

1. Small.
2. Led by a dedicated founder(s).
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 it may not be the "sure thing" it's advertised as.

A case study
Consider, for example, the cases of HLTH (Nasdaq: HLTH) and Lululemon Athletica (Nasdaq: LULU) -- an Internet health-care company and a yoga apparel maker that have recently been pitched to me at cocktail parties, golf outings, weddings, and, of course, on the Internet.

Are they small? Fairly. Both companies are capitalized at around $2 billion.

Are they led by dedicated founders? No and yes. While HLTH has a fair dose of insider ownership (approaching 6%), the CEO has only been on the job since 2004 and recently took a health-related leave of absence. Lululemon founder Dennis Wilson, on the other hand, serves as the company's chairman and chief product designer and owns 38% of the company.

Are they fiscally conservative? While both companies are profitable and cash-flow positive, Lululemon has seen its SG&A expenses increase slightly faster than revenue. That's not necessarily a red flag, but it's worth keeping an eye on.

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.

Furthermore, Lululemon may be benefiting from more of a short-term yoga fad.

The Foolish final word
I'm not here to be negative about either HLTH or Lululemon. Both have positive traits and their recent stock price drops make them more attractive opportunities than they were just a few short months ago.

As you set about analyzing companies you think could be "the next [fill in the blank]," remember the four-step framework. This is one of the ways we start our research process for 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 a dedicated founder(s).
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 nearly 19 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 Oct. 19, 2006. It has been updated.

Tim Hanson does not own shares of any company mentioned. Costco is a Stock Advisor recommendation. The Fool's disclosure policy assures you that no stocks were harmed in the penning of this article.