The Simple Way to Find Market-Beating Stocks

If you ask me, every investor should get the phrase "Keep it simple, stupid!" tattooed somewhere that makes it easy to glance at 50 times per day (give or take a few).

A lot of heartache could be avoided with this strategy. Take the financial crisis for instance. Complicated Wall Street models told the wonks in New York that it was A-OK to keep right on cooking up mortgage derivatives in 2006 and 2007. If they all had my suggested tattoo then they all would have looked up from their models, rubbed their eyes, and said "None of this makes a lick of sense." Crisis averted.

While I haven't gotten myself inked up quite yet, I do try to remind myself on a regular basis to get my head out of the books and newspapers, close my Excel models, and simplify things.

To get really basic, let's start with the goal of beating the market. Now how are we going to do that? In the simplest terms, we need to focus on four things: Company growth, valuation, dividends, and share growth.

Four to score
Each item in that list plays its own part in determining just how much you're going to cash in on your investment.

• Growth: In most cases we're talking about profits here. We can easily see how much Gary's Gumbo Shack earns today, but how much will it be banking five years from now?
• Valuation: No spreadsheets here, we're talking specifically about the multiple of earnings investors are willing to pay for a stock. If investors are paying 20 times earnings for Gary's today, do we think it's likely that they'll award the same multiple five years hence?
• Dividends: If a company makes it a practice to pay out its profits to investors, then the total dividends that you think you'll collect will be a key component of your returns.
• Share growth: Some companies need to issue new shares to fund the business, some pay their employees with stock, others buy back shares hand over fist. If there are more shares outstanding five years from now, that'll provide a drag on returns, while a lower share count will be a tailwind.

Simplicity in action
Potash Corp (NYSE: POT) has been an absolute monster performer over the past decade, returning an amazing 1,158% (including dividends).

These returns were a result of the four items outlined above. Over that period, the company's operating earnings have grown 571% as a result of a 171% increase in revenue and an operating margin that expanded from 15% to 38%. At the beginning of 2001, investors were willing to pay 22 times Potash Corps' trailing earnings per share for the stock, while today they're coughing up 31 times earnings.

Potash Corp doesn't pay a huge dividend, but over ten years it's returned $790 million -- or $2.64 per share -- through its dividends. Meanwhile, the company has used cash flow to make a few large share buybacks and has lowered its share count by 4%.

Put those four points together and you get the stock's hefty return. Looking ahead, the math will be very similar. How fast will Potash Corp be able to grow earnings? How much will investors pay for those earnings? Will cash flow continue to be used to pay dividends and lower the share count?

Don't get me wrong, answering these questions is far from easy -- we're talking about the future after all. But these four points give us a very simple starting point to figure out whether a stock is a worthwhile investment.

The four-point plan
As an investor, you don't have to rely on all four points for your returns. Growth investors can spend most of their time figuring out the potential for earnings growth, while dividend investors would focus on, well, dividends. Heck, Autozone (NYSE: AZO) has produced stellar returns largely through aggressively buying back shares -- something that it continues to do today.

That said, all four points still need to be attended to. A growth investor, for example, may correctly identify a stellar grower, but end up with lousy returns because they paid too much for that growth (ask Sanofi-Aventis shareholders about that).

As for me, my forte is dividends, so my four-point-based search would start there with a requirement of a 3%-or-better dividend yield. While investors can certainly pay a higher multiple for an already-high-multiple stock, it's generally more likely that they'll award a higher multiple to a low-multiple stock, so I want a forward price-to-earnings multiple of 12 or less. I don't want a shrinking business, so I'll require analyst-estimated growth of 7%. Finally, I don't want any companies that have grown their share count at a faster pace than 2% per year over the past five years.

Here are five of the names that popped up using those criteria.

Source: Capital IQ, a Standard & Poor's company.

The stocks above are all starting points for more research. That research should focus on pressure-testing the implied assumptions of the numbers above. Are the companies' balance sheets strong enough to continue to pay those -- or, better yet, higher -- dividends and not have to issue new shares? Might investors pay a higher multiple for their earnings in the future? Are those growth rates achievable?

As I noted above, that research may not always be particularly easy, but the approach is simple. And in what can be a very overwhelming world of investing, a little simplicity can go a long way.

Want more simplicity? My fellow Fools picked one stock as their top pick for 2011. Check out this free special report to find out the identity of that mystery stock.