How to Find the Best Companies to Buy Stock In

So you're looking to buy stocks but aren't sure how to value them or decide which are the most attractive? It's a challenge for most newbie investors because it's hard to sift through the mass of numbers and stats thrown at you. To help you make sense of it all, here's my view on how to think about investing, and a demonstration of a method you can easily use to find suitable stocks for your portfolio.

Let me be clear: The stocks I'll be discussing here aren't intended to construct a perfect portfolio in and of themselves, but rather to illustrate how you might go about the process. I've limited my examples to one business sector (industrials) because that makes it easier to demonstrate my key point: All companies have a life cycle, and a stock's valuation should be based on where the company is within that life cycle. The real trick to investing is identifying which stage a company is currently in.

Finding the best stocks to invest in can be confusing. Image source: Getty Images

The life cycle of a company

You can think of it like this: A typical company starts out with high growth and minimal to negative free cash flow (FCF), then progresses into having growth with earnings and cash flow. As it matures, it grows larger and starts generating revenue growth higher than that of the country's gross domestic product (GDP) with good margin and cash flow, before experiencing GDP-or-less revenue growth but high cash flow generation.

You want to find a way to value a company at each stage of this cycle, and then see if the company's market value matches your assumptions or not.

I believe the best way to invest is to find a company priced as if it were, say, a growth company, but that is actually a high-growth company. Similarly, you might find a growth company priced as a maturing company or a maturing company priced as a cash cow. The point in these examples is that the market is mispricing the stock according to what you think it's worth. 

As you can see below, as a company grows up, its growth rate starts to slow and it generates more earnings and FCF. This is often reflected in the way that investors rate the stock -- so, for example, the market might value a growth company on a 3% FCF yield (FCF divided by market cap) and a maturing company would trade on around a 5% yield. I'm arguing that these FCF yields represent a fair value for the stock. 

Data source: Author's opinion. Free cash flow yield is free cash flow divided by market cap.

In case you're wondering why I'm using 5% as a rough approximation for FCF yield for a maturing company, it's because the 10-year Treasury yield is approximately 5%, and I believe that an investment in a maturing business -- albeit with GDP-plus revenue growth -- should yield the same as a risk-free Treasury in terms of FCF. (There is strong evidence that 10-year Treasury bond yields equate to U.S. nominal GDP growth, and even though the 10-year yield is around 2.4% now, I'm going to conservatively assume a rate equal to the current 5.3% nominal GDP growth rate.) 

Some practical examples

Armed with the theory, it's time to look at some specific stocks and discuss whether they are a fair value or not. These are all industrial stocks at different stages of development, and they all have free cash flow generation (this helps to simplify comparisons in this model).

Data source: Company presentations. Author's analysis. Growth figures are averages for the last three years.

Cognex Corporation's machine vision solutions offer a unique way to benefit from e-commerce and robotics in one stock. Its factory automation sales and e-commerce fulfillment-related sales are growing at 20% and 50% a year, respectively. This is a high-growth company, and as you can see in the table, it's now priced as one.

Ultimately, if you believe in Cognex's high-growth prospects, which are tied to attractive long-term trends like increasing use of automation in manufacturing and machine vision in consumer electronics -- Apple is Cognex's largest single customer -- then you would want to buy the stock if it were priced as a growth company. An FCF yield of around 3% (or price-to-FCF of 33 times) for Cognex would be a good value. So Cognex looks fairly valued to me. 

Following a similar line of argument, Heico Corporation's double-digit growth prospects make it a growth stock, but ideally, investors would want to buy the stock priced as if it were a maturing company -- say, on a 4% FCF yield (or 25 times FCF). Heico's growth is driven by the booming aerospace industry and increasing usage of electronics on aircraft. Meanwhile, its manufacture and repair of Federal Aviation Administration-approved parts for aircraft offers customers a cost-effective way to buy and service parts.

As you can see below, you could have bought Cognex and Heico at the start of 2016 when Cognex was at a 3% FCF yield (a high-growth company priced as a growth company) and Heico was at an FCF yield of 4.1% (a growth company priced between growth and maturing). Their stock returns since January 2016 are 293% and 120%, respectively.

CGNX Price to Free Cash Flow (TTM) data by YCharts.

Both Honeywell and Ingersoll-Rand operate in mature industries, and they are starting to look more than fairly valued on an FCF basis. However, they are both increasing their margin and cash flow generation. In other words, they are still at the growth end of the maturing phase. Honeywell is coming out of a period of heavy capital investment and is set to significantly increase its FCF in the coming years.

Honeywell's investing has been focused on increasing its organic growth rate, and this appears to be working. After a year of negative organic sales growth in 2016, the company is estimated to have 4% growth in 2017 and 2%-4% in 2018.  Based on management's estimates, it trades on a forward FCF yield of around 4.5% -- not bad for a company set for high-single-digit earnings growth in the coming years.

Meanwhile, Ingersoll-Rand continues to expand its operating margin -- notably with its core Trane air-conditioning operations -- and is targeting 11%-13% earnings growth in the medium term. The company has a long-term growth opportunity from expanding sales in emerging markets, notably China, while productivity initiatives are generating ongoing margin expansion. Trading on a projected 2017 FCF yield of 5.3%, Ingersoll-Rand is a growth stock trading on the valuation of a maturing company -- usually a good buy for investors.

The bottom line

All told, finding the best companies to invest in is never going to be a simple task, but it helps to understand where a company is in its life cycle and then gauge whether it's appropriately priced or not -- particularly, compared to the kind of yield you might get from a risk-free asset such as a 10-year Treasury.

On this methodological basis, stocks like Honeywell and Ingersoll-Rand are worth buying, and with any kind of significant dip in their stock prices, Heico and Cognex are worth picking up, too. While these four stocks should by no means constitute your entire portfolio -- it's important to make sure your portfolio contains a diverse set of companies, from different sectors and with different end markets driving their business -- this exercise demonstrates a useful way to pick out the best stocks to buy within a sector of your choice.