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.

It's a fairly appealing enticement. After all, Costco, TD Ameritrade, Yahoo!, and Intuit are some of the stock market's great success stories. These companies earned early investors mind-boggling returns.

The secrets of success
Does that one stock you must buy exist? Of course it does. But can you find it? That's a different matter.

However, here's 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?

We're not saying that your one stock will be a big-box store or a tech superstar. But 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, 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, respectively, that have recently been pitched to me at cocktail parties, golf outings, weddings, and of course, on the Internet.

Are they small? Sure. HLTH is worth around $1.2 billion, and Lululemon is valued at $870 million.

Are they led by dedicated founders? No and yes. While HLTH has a fair dose of insider ownership (more than 8%), there's been some movement in and out of the CEO's office. Lululemon founder Dennis Wilson, on the other hand, serves as the company's chairman and chief product designer and owns 7% of the company (though that ownership stake has been declining).

Are they fiscally conservative? While both companies are profitable and cash-flow positive, Lululemon needs to keep an eye on its SG&A expenses, and HLTH has had some lumpy operating performance.

Do they have wide market opportunities? That answer gets a little cloudy. While both companies' products have received good reviews, both also face significant competition going forward. Furthermore, Lululemon may have been benefiting from a short-term yoga fad that could get pinched in a down economy.

The Foolish final word
I'm not here to be negative about either HLTH or Lululemon. Both have positive traits that could make them good investments.

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, click here to join Hidden Gems free for 30 days.

Already a Hidden Gems subscriber? Log in at the top of this page.

This article was originally published Oct. 19, 2006. It has been updated.

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