There will always be companies that are obviously great investments -- in hindsight. Looking through the rearview mirror, we know we should have bought Starbucks or Wal-Mart at their IPO and realized returns of tens of thousands of percent over the years. Yet for every stock out there screaming "buy me," there are others that simply give us a nudge in the ribs and a knowing nod. They may be tomorrow's obviously great investments, but how do we tell them from the thousands of pretenders?
The stars walk of fame
Over on the investor intelligence site Motley Fool CAPS, we know these opportunities as four-star stocks -- companies that rank higher than most of the other 5,000 stocks in the CAPS universe, but that are just shy of achieving stardom. In the long shadows of stocks that garner the coveted five-star rating are top-tier companies approaching greatness.
While the full "secret sauce" of how the ratings are calculated is kept proprietary, there are three factors that influence a stock's star rating:
- Whether a stock is rated "outperform" or "underperform"
- The length of time it is expected to perform (a few months or a few years)
- The ratings of the investors who make the picks.
Every player is rated just as every stock is rated. The best and brightest of these players are considered All-Stars, and since they are correct more consistently than their peers, their opinions weigh more heavily in favor of (or against!) a stock.
Searching out of the spotlight
So while all the attention might be focused on the five-star stocks, good investments slip under the radar with only four stars. Yet we can sift through the CAPS database to find some of these four-star companies approaching greatness:
You might find some of the names surprising. After all, even though it changed its name from Philip Morris to sever the negative association with tobacco, people still know what Altria makes. But sometimes, we find that the most familiar names can bring some of the best investment opportunities, because we have forgotten about the potential they still hold. Just as meaningful, those among the 70,000 investors on CAPS who rated these companies are giving them the nod as less obvious places to look for tomorrow's great buys. So let's delve into why these companies might merit your attention.
The nuances of speech recognition
It's these long-term opportunities that can earn you the greatest profits. Nuance Communications supplies corporate call centers with voice-recognition technology that is used for voice-to-text translation and controlling devices through speech. It has been on an acquisitions tear, buying up anything that might be a competitor in its field. One competitor it can't buy is Microsoft, which wants to deploy its own voice-recognition technology. By establishing itself early and eliminating rivals, Nuance has given itself first-mover status in an emerging industry. Will that be enough to stave off its nemesis in Redmond, though?
More than 4,500 CAPS investors think so! They've rated the Motley Fool Hidden Gems recommendation to outperform by a wide margin. While acquisition-happy companies tend to falter, that hasn't been the case with Nuance. All-Star investor TheGarcipian, with a 99.88 player rating, has noted that those acquisitions have almost immediately been accretive to the bottom line.
I thought they had (and still have) an interesting acquisition model, and having lived through several acquisitions in my high-tech job, I know that these acquisitions have a success rate very similar to that of marriages in the USA: 50%. The fact that Nuance has been able to continue its acquisitions and have those add to the bottom line so quickly is testament to the excellent management here. While they are cash-flow positive, the margins are either negative (the profit margin is -3.2% as of Oct. 12) or in the single digits (the operating margin is 8.2%). They've recently increased their debt load (debt-to-equity is 59%), and their enterprise value-to-EBITDA is very high, at 45.4. None of these numbers are good by themselves, but they start to shine when coupled with management's talent for buying and integrating key technologies. And given that Nuance has a wad of cash equal to one-third its annual revenue, I think we will see rising margins, growing EPS, and generally positive improvements in the balance and income sheets, all of which should continue to raise the stock price. The key, however, is management. Let's hope they don't make any missteps.
A great opportunity for you
That's the current word on Nuance Communications, but what are your thoughts? Are these four-star stocks still investment grade material? On Motley Fool CAPS, you can give input that will ultimately influence how these stocks are rated. Outperform or underperform, near-term or well in the future, your opinion counts.
Sign up today for Motley Fool CAPS and let us hear what you have to say about the great and almost great companies that interest you; it's completely free.
Nuance Communications is a recommendation of Motley Fool Hidden Gems. Get a 30-day free trial subscription and see all of the newsletter's market-beating recommendations.
Fool contributor Rich Duprey owns shares of Wal-Mart, but does not have a financial position in any of the other stocks mentioned in this article. You can see his holdings here. Microsoft and Wal-Mart are recommendations of Motley Fool Inside Value. Starbucks is a recommendation of Motley Fool Stock Advisor. The Motley Fool has a disclosure policy.