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3 Simple Ways to Search for the Next Home Run Stock

By Cory Renauer, Brian Stoffel, and Brian Feroldi – Jul 15, 2016 at 11:22AM

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Picking winners doesn't have to be complicated. Here are three simple tricks our contributors use.

Searching the best financial investment

Image source: Getty Images.

Every day the stock market offers thousands of potential opportunities for gains and losses. With huge swaths of data and endless ways to interpret it available, you might think only geniuses can pick stocks. 

Nothing could be further from the truth -- and to prove it, we asked three Motley Fool contributors to share simple tips for picking winners. Keep reading to learn how they find home run stocks.

Buy companies with high switching costs

Brian Feroldi: One way to find a home run stock is to buy companies with the widest economic moat that you can find. A company can build a wide moat is by creating switching costs for its customers. Think of these as one-time inconveniences or expenses that a customer would incur if they decided to switch to a competing product. If a company can make it a hassle for its customer to switch to a competing product, then it stands a greater chance of keeping its customers for a long period of time.

One such company that has huge switching costs working in its favor is Intuitive Surgical (ISRG 0.26%), the leader in robotic surgery. Installing one of the company's da Vinci systems is a huge undertaking, so you can bet that its customers would loath having to switch vendors. After all, before a customer signs on, they need to have a surgical space available, their staff needs to be fully trained, and they have to pay more than a million dollars to get the system. That's a lot of time and money that needs to be spent up-front to get up and running, so once all of that is behind them, it becomes an enormous burden for the customer to switch to a competing system. 

That fact is really great for investors, as it helps to keep Intuitive Surgical's customers locked in. Since the majority of Intuitive Surgical's revenue now comes from service contracts and disposable instrument sales, the company's revenue and margins have become quite predictable. That allows management to keep its attention focused on expanding the company's product offering and on finding and training new customers.

This business model is really powerful, so perhaps its no surprise that Intuitive Surgical's stock has smashed the market over the past 10 years.

ISRG Chart

ISRG data by YCharts.

So when you are hunting for a company with a wide moat, ask yourself if it would be a big hassle for the company's customers to switch to a different vendor. If the answer is yes, then you might have found a winning stock.

Look for platforms with the network effect

Brian Stoffel: Having just been bought out by Microsoft (MSFT -0.04%) for a solid premium, let's use LinkedIn (LNKD.DL) as an example of a stock that had home run potential. It created a platform that attracted both individuals and companies.

The network effect worked like this: With each additional user, companies had a greater incentive to use LinkedIn for their HR needs. And when a company joined LinkedIn to find employees, individual users had even more incentive to sign up with the website. It's a virtuous cycle that can help a company grow exponentially.

Once a company builds up a platform that attracts so many users, it can be very difficult for competition to create a rival that can draw users away.

The same holds true for many popular companies today. Outside of social media, Priceline (BKNG 0.77%) -- a stock that's returned 4,500% over the past 10 years -- serves as a prime example. The company counts on its Booking.com platform for a huge bulk of its revenue. With each additional hotel or B&B that lists on Booking.com, travelers have additional motivation to use the website, and with each additional traveler, those who offer accommodations will increasingly list on the site.

So when you're looking for the next home run stock, look for platforms that benefit from the network effect.

Look for fixable problems

Cory Renauer: Recognizing a company's downturn as a temporary issue is a great way to find long-term winners in a market consumed by present results. In 2012 Alphabet (GOOG -1.24%) (GOOGL -1.02%) recorded a dip in sales and earnings as use of mobile devices soared.

With desktop style AdWord revenue responsible for the vast majority of the company's revenue, fears Alphabet wouldn't be able to continue its phenomenal rate of earnings growth in a world dominated by mobile devices sent the shares to a trailing P/E ratio it hasn't seen since.

GOOGL PE Ratio (TTM) Chart

GOOGL PE Ratio (TTM) data by YCharts.

Much earlier in Alphabet's history, founder and now CEO Larry Page saw some searches resulted in AdWord results that were completely irrelevant to the user because of the bids their advertisers were willing to pay for a click. That Friday afternoon he tacked printouts of some offending examples to a board in the kitchen and wrote "These ads suck" across the top, then walked out without saying a word.

Early Monday morning, engineers that weren't even responsible for ads had begun circulating an assessment of the problem, and a prototype that solved it.

The mobile revolution was moving fast, but I was confident that Alphabet, which already had the dominant mobile operating system, could catch up. I was right.

GOOGL EPS Basic (TTM) Chart

GOOGL EPS Basic (TTM) data by YCharts.

Stretched out over a decade, Alphabet's earnings maintained their trajectory, and the temporary downturn looks like a mere blip.

I'm not what you would call a growth stock investor, and the shares I scooped up during the overreaction to a fixable problem comprise a much larger portion my portfolio than I had intended. It's a problem I can live with.

Suzanne Frey, an executive at Alphabet, is a member of The Motley Fool's board of directors. Brian Feroldi owns shares of Alphabet (A shares), Alphabet (C shares), Intuitive Surgical, LinkedIn, and Priceline Group. Brian Stoffel owns shares of Alphabet (A shares), Alphabet (C shares), Intuitive Surgical, and Priceline Group. Cory Renauer owns shares of Alphabet (A shares) and Alphabet (C shares). The Motley Fool owns shares of and recommends Alphabet (A shares), Alphabet (C shares), Intuitive Surgical, and Priceline Group. The Motley Fool owns shares of LinkedIn and Microsoft. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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Stocks Mentioned

Microsoft Stock Quote
Microsoft
MSFT
$247.49 (-0.04%) $0.09
Alphabet (A shares) Stock Quote
Alphabet (A shares)
GOOGL
$97.46 (-1.02%) $-1.00
LinkedIn Corporation Stock Quote
LinkedIn Corporation
LNKD.DL
Booking Holdings Stock Quote
Booking Holdings
BKNG
$1,984.63 (0.77%) $15.18
Intuitive Surgical Stock Quote
Intuitive Surgical
ISRG
$265.13 (0.26%) $0.68
Alphabet (C shares) Stock Quote
Alphabet (C shares)
GOOG
$97.60 (-1.24%) $-1.22

*Average returns of all recommendations since inception. Cost basis and return based on previous market day close.

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