What's the best way to identify stocks that have what it takes to shellac the market over the long haul? For my money, it's this: make them show you the money.
Free cash flow (FCF) that is. During these turbulent times, admittedly, even FCF stalwarts have been smacked around, with the likes of AT&T (NYSE: T), Chevron (NYSE: CVX), and Pfizer (NYSE: PFE) -- fat cash cows all -- trading fairly close to their respective 52-week lows. ConocoPhillips (NYSE: COP) and Coca-Cola (NYSE: KO) fit that profile as well.
Recent declines aside, the bottom line is this: When the fog of recession finally lifts, it's precisely these kinds of companies -- value-priced titans with healthy levels of FCF -- that will likely be the first to lead us out of the doldrums. That has been the historical norm, after all. And actually, that leadership will likely begin before the recession, um, recedes: The market typically begins its upswing well in advance of the overall economy's.
With that said ...
There's of course more to smart stock selection than just cherry-picking from among a list of proven cash machines. Even great companies can make lousy investments if, for example, management has lost the knack for getting the biggest bang for its shareholders' bucks. On that front, return-on-equity -- a key measure of profitability -- is a good metric.
As we point out in the Fool's glossary, ROE (as the cool kids like to call it):
... is a measure of how much in earnings a company generates in four quarters compared to its shareholders' equity. It is measured as a percentage. For instance, if XYZ Corp. made $1 million in the past year and has shareholders' equity of $10 million, then the ROE is 10%.
This Foolish write-up offers a fuller take on this important investing topic, but the thing to remember about ROE is this: The higher the figure the better. Large (and increasing) percentages generally indicate that management is doing a fine job of wringing profit from the money its shareholders have at stake.
Example of companies that have exceptional track records of delivering the ROE goods include 3M (NYSE: MMM) and PepsiCo (NYSE: PEP). Each posted juicy ROE figures in its most recently concluded fiscal year, easily trumping their respective industry averages. Both firms have continued to fare well in ROE terms since then, too, and given that they also have exemplary track records of generating ample sums of free cash flow, savvy investors will likely want to place them near the top their further-research list.
But on the other hand ...
If, however, you'd prefer to plunk down your hard-earned moola on stocks that have already been Foolishly vetted for FCF, ROE, and a host of other important financial metrics, we encourage you to consider taking the Fool's Ready-Made Millionaire for a spin when it reopens to new members early next year.
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This article was originally published on December 3, 2008. It has been updated.
Shannon Zimmerman runs point on the Fool's Ready-Made Millionaire and doesn't own any of the companies mentioned. Coke, 3M, and Pfizer are Inside Value recommendations. Pfizer and PepsiCo are Income Investor selections. The Fool owns shares of Pfizer. You can check out the Fool's strict disclosure policy by clicking right here.
