Every investor would love to stumble upon the perfect stock. But will you ever really find a stock that provides everything you could possibly want?
One thing's for sure: You'll never discover truly great investments unless you actively look for them. Let's discuss the ideal qualities of a perfect stock, then decide if Merck (NYSE: MRK ) fits the bill.
The quest for perfection
Stocks that look great based on one factor may prove horrible elsewhere, making due diligence a crucial part of your investing research. The best stocks excel in many different areas, including these important factors:
- Growth. Expanding businesses show healthy revenue growth. While past growth is no guarantee that revenue will keep rising, it's certainly a better sign than a stagnant top line.
- Margins. Higher sales mean nothing if a company can't produce profits from them. Strong margins ensure that company can turn revenue into profit.
- Balance sheet. At debt-laden companies, banks and bondholders compete with shareholders for management's attention. Companies with strong balance sheets don't have to worry about the distraction of debt.
- Money-making opportunities. Return on equity helps measure how well a company is finding opportunities to turn its resources into profitable business endeavors.
- Valuation. You can't afford to pay too much for even the best companies. By using normalized figures, you can see how a stock's simple earnings multiple fits into a longer-term context.
- Dividends. For tangible proof of profits, a check to shareholders every three months can't be beat. Companies with solid dividends and strong commitments to increasing payouts treat shareholders well.
With those factors in mind, let's take a closer look at Merck.
What We Want to See
Pass or Fail?
|Growth||5-Year Annual Revenue Growth > 15%||16.4%||Pass|
|1-Year Revenue Growth > 12%||8.8%||Fail|
|Margins||Gross Margin > 35%||69.4%||Pass|
|Net Margin > 15%||8.8%||Fail|
|Balance Sheet||Debt to Equity < 50%||31.5%||Pass|
|Current Ratio > 1.3||2.06||Pass|
|Opportunities||Return on Equity > 15%||7.5%||Fail|
|Valuation||Normalized P/E < 20||14.31||Pass|
|Dividends||Current Yield > 2%||5.0%||Pass|
|5-Year Dividend Growth > 10%||0%||Fail|
|Total Score||6 out of 10|
Source: S&P Capital IQ. Total score = number of passes.
Since we looked at Merck last year, the drugmaker has fallen back by a point. Net margins that fell by more than half were the primary culprit, although a drop in the stock's earnings multiple helped cushion the blow.
Like most other pharma companies, Merck is dealing with the imminent loss of patent protection on one of its blockbuster drugs. Merck will have to face generic competition on asthma treatment Singulair next year. That makes it hard to predict the company's future, although Merck's decision to sustain its R&D spending is a definite positive in building its future pipeline.
But past mistakes have come back to haunt the company. Earlier this week, the Department of Justice announced that Merck would pay a staggering $950 million to resolve issues related to its Vioxx painkiller drug, which the company pulled back in 2004 after evidence showed increased the risk of heart attack and stroke. The amount includes both criminal fines and a civil settlement.
Still, even with those concerns, Merck seems confident. The company boosted its dividend for the first time since 2004 earlier this month and now yields close to 5%, well in excess of rivals Pfizer (NYSE: PFE ) , Johnson & Johnson (NYSE: JNJ ) , and Abbott Labs (NYSE: ABT ) .
The key to Merck's future is building up its stable of drugs in development to replace expiring patents. That could prove difficult if the company's recent experience in losing out to Vertex Pharmaceuticals (Nasdaq: VRTX ) in the hepatitis C market bears out in other pipeline drugs. Without new blockbusters, Merck could get a lot further away from perfection in the years ahead.
No stock is a sure thing, but some stocks are a lot closer to perfect than others. By looking for the perfect stock, you'll go a long way toward improving your investing prowess and learning how to separate out the best investments from the rest.
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Finding the perfect stock is only one piece of a successful investment strategy. Get the big picture by taking a look at our "13 Steps to Investing Foolishly."