5 Investing Criteria I've Used to Beat the Market

With thousands of stocks to pick from and a multitude of financial metrics one can use to judge companies' performance and growth potential, how can investors be sure they are making the best possible decisions?

Under conditions of complexity, not only are checklists a help, they are required for success. -- Atul Gawande, surgeon and author of The Checklist Manifesto

Over a year ago, I decided to take Gawande's advice and created a detailed checklist of the attributes I wanted in my stocks. Since I started using this checklist in my decision-making, my portfolio's returns have improved -- considerably. Is this just a coincidence? I don't think so.

Let's take a look at five key criteria from my list.

1. Solid and sustained revenue growth

For me, "solid" revenue growth means at least 15% year over year, and "sustained" means it has continued for years, not just a few quarters. E-commerce operating platform Shopify (SHOP -2.37%), exemplifies this attribute.

Image source: Shopify

Since 2016, it has put up annual revenue growth in excess of 45%. Although that growth rate has slowed, gains in the 40%-plus range when annual revenue is over $1 billion puts Shopify in a category that few companies can match. This kind of growth over the long term demonstrates that the company's offerings are valuable to its clients, and indicates its platform has a sustainable competitive advantage.

2. A recurring revenue stream

Quality of revenue is also important. A stable revenue stream is preferable to one that is lumpy or dependent on large product sales. Going through the selling process once with a customer and then being able to count that customer over the long term is tremendously valuable. Not only does it make for a more efficient sales process, but it gives leadership better visibility so they can more confidently invest in growth efforts.

DocuSign's (DOCU 1.02%) e-signature business gets 95% of its revenue from recurring subscription fees. Almost a third of the dollar value of its contracts is in those that are longer than 12 months, which provides tremendous stability in cash flows. That enables it to focus on capturing incremental revenue rather than having to start every quarter at zero.

Checklists can be a powerful investing tool. Image source: Getty Images.

3. A sticky product driving customers to spend more 

Making that first sale to win a customer can be a lengthy process, but the second sale to that same customer is usually much easier. Veeva's (VEEV -0.29%) end-to-end product platform that helps life sciences companies run their business is a textbook model of how a sticky product can entice customers to expand their spending over time.

Customers usually come to Veeva to help digitize one area of the business due to a regulatory or process inefficiency, but that's just the beginning. Because of the platform's ability to handle all facets of a life science company's operation, customers can over time extend their benefits by transitioning more aspects of their business to it. In Veeva's 2019 investor day presentation, management shared that the customers it attracted in 2013-2014 had expanded their usage to 3.8 products over the subsequent years, lifting their annual spending with the company to 20 times their first-year rate.

The more deeply customers embed Veeva's products in their operations, the harder it becomes to switch to a competitor, further fortifying its revenue.

4. Founder-led with a deep bench

Studies have shown that companies where a founder is still involved in running the operation provide better returns than those that aren't. And not just marginally better returns: According to a Bain study published in 2016, founder-involved companies had three times greater stock gains over a 15-year period. I take this criterion one step further, though, and look for founders who surround themselves with a deep bench of talent.

MercadoLibre's (MELI -1.79%) management team epitomizes this investing attribute well. Not only is the founder, Marcos Galperin, still serving as CEO and president, but his C-suite is stacked with long-standing leaders who have a wealth of experience in its operations.

Source: Mercado Libre 2019 annual report. Table by author. 

This expert team not only knows the operations inside and out, but has extensive experience working together. That should leave investors confident that they could lead their company through just about any challenge.

5. An asset-light business

The last of the five criteria relates to the physical assets required to generate revenue. Etsy (ETSY -2.17%), the online marketplace for artisans, doesn't need infrastructure such as physical stores, manufacturing facilities, or distribution centers. It does have a headquarters building for its staff, and it partners with Alphabet's Google to host its website, but that's all the infrastructure it needs to execute its mission. This enables it to be flexible and resilient regardless of economic conditions (or even global pandemics).

The takeaway for investors

To know thyself is the beginning of wisdom. -- Socrates

This is by no means intended to be an exhaustive list of criteria for investors to weigh when picking stocks. My complete checklist has 18 items to help define which stocks I want in my portfolio -- and which ones I don't. The process of creating and using that list has helped me better understand my investing style, made it easier to remain consistent with my choices, and given me more confidence. Oh yeah, and helped me produced solid, market-beating results -- that's a really nice benefit too. 

It turns out that I'm not the first Fool writer named Brian to develop and use an investing checklist. You can find Brian Stoffel's antifragile process here, and Brian Feroldi's business quality scoring methodology here. Motley Fool analyst John Rotonti has also shared the comprehensive checklist that he uses here, along with insights about putting it to use.

If you don't have your own checklist, maybe it's time you started one.