Stop me if you've heard this one. The one stock you must buy is ... the next Netflix
That's a pitch I'm sure you've heard some semblance of at cocktail parties, golf outings, weddings, and, of course, on the Internet.
And it's a pretty appealing pitch. After all, Netflix, Hansen Natural, Home Depot, and Berkshire Hathaway are some of the stock market's greatest successes. These companies have earned early investors fantastic returns over short and long periods of time.
The secrets of success
So the question is: Does that one stock you must buy exist? Of course it does. But can you find it? That's a different matter.
Here, however, is a litmus test to gauge every stock tip you come across. Simply ask: Does this company bear any resemblance at all to Netflix, Hansen Natural, Home Depot, or Berkshire before they were big names?
That's not to say that one stock will be a tech superstar, or be run by a superstar investor. Instead, Netflix, Hansen Natural, Home Depot, and Berkshire all share a set of remarkable traits that characterized them when their amazing runs began. All were:
- Small.
- Led by dedicated founders or long-tenured CEOs.
- Fiscally conservative.
- Profiting from a wide market opportunity.
If the next stock that's pitched to you doesn't possess these traits, you're probably better off passing.
A case study
Consider, for example, the cases of Sun Microsystems
Are they small? No. Both are capitalized at around $7 billion.
Are they led by long-tenured leaders? One definitely is. Scott McNealy co-founded Sun Microsystems in 1982, served as CEO from 1984 to 2006, and continues to sit as chairman. Though Citrix Systems CEO Mark Templeton has a long tenure with the company -- he's been with Citrix in some capacity since 1995 -- he left his post as CEO for a full year in 2000-2001 while the board searched (in vain) for new leadership. While he's done an admirable job, Templeton probably doesn't pass this test.
Are they fiscally conservative? Yes and no. While both companies have strong balance sheets and decent cash flows, Sun Microsystems just took a massive goodwill impairment and its margins have declined while its capital expenditures rise.
Do they have wide market opportunities? It gets a little cloudy here. While both companies have solid products and opportunities to grab greater market share, they both operate in extremely competitive industries -- as evidenced by the rising capital spending. Whatever gains they make will be hard-fought, and they may not last.
The Foolish final word
I'm not here to be negative about either Sun Microsystems or Citrix Systems. Both have positive traits, and they could make for good investments going forward. However, I don't think either one has the core traits that made companies like Netflix, Hansen Natural, Home Depot, and Berkshire such incredible investments -- the traits we seek in our Motley Fool Hidden Gems small-cap investing service.
Again, we believe that tomorrow's best investments will start off:
- Small.
- Led by dedicated founders or long-tenured CEOs.
- Fiscally conservative.
- Profiting from a wide market opportunity.
If you'd like to take a look at the companies we've found that meet those four criteria, click here to join Hidden Gems free for 30 days.
Already subscribe to Hidden Gems? Log in at the top of this page.
This article was originally published on Oct. 19, 2006. It has been updated.
Tim Hanson owns shares of Berkshire Hathaway, as does The Motley Fool. Berkshire and Netflix are Motley Fool Stock Advisor recommendations. Berkshire and Home Depot are Inside Value picks. Hansen Natural is a Rule Breakers choice. The Fool's disclosure policy assures you that no stocks were harmed in the penning of this article.
