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 Novavax (Nasdaq: NVAX) and lululemon athletica (Nasdaq: LULU) -- a pharmaceutical 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. Novavax is worth around $367 million, and lululemon is valued at $1.8 billion.

Are they led by dedicated founders? No and yes. Novavax's CEO has been in his post only since 2005; lululemon founder Dennis Wilson serves as his company's chairman and chief product designer and owns 7% of the company.

Are they fiscally conservative? Although lululemon is profitable and cash-flow positive, it needs to keep an eye on its SG&A expenses. Novavax, on the other hand, resembles many small biotechs and is currently burning cash.

Do they have wide market opportunities? That answer gets a little cloudy. For its part, lululemon may have been benefiting from a short-term yoga fad that could get pinched in a down economy. Novavax is looking to cash in on an H1N1 flu vaccine in the near term, but its long-term plans are less clear.

The Foolish final word
I'm not here to be negative about either Novavax or lululemon. Both have positive traits that could make them good investments. And while lululemon looks like the stronger long-term opportunity against this framework, before investing you'll want to make a decision about either the appeal of yoga or of the company's ability to enter other athletic niches.

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, which is a Motley Fool Stock Advisor and Inside Value recommendation. The Fool also owns shares of Costco. The Fool's disclosure policy assures you that no stocks were harmed in the penning of this article.