Stop me if you've heard this one. The one stock you must buy is ... the next Costco
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.
It's a fairly appealing enticement. After all, Costco, TD AMERITRADE, Yahoo!, and Intuit are some of the stock market's great success stories. These companies earned early investors mind-boggling returns.
The secrets of success
Does that one stock you must buy exist? Of course it does. But can you find it? That's a different matter.
However, here's a litmus test to gauge every stock tip you come across. Simply ask: Does this company bear any resemblance at all to Costco, TD AMERITRADE, Yahoo!, and Intuit before they were big names?
I'm not saying that your one stock will be a big-box store or a tech superstar. But Costco, TD AMERITRADE, Yahoo!, and Intuit all share a set of remarkable traits that characterized them when their amazing runs began. All were:
1. Small
2. Led by a dedicated founder(s)
3. Fiscally conservative
4. Profiting from a wide market opportunity
If the next stock that's pitched to you doesn't possess these traits, it may not be the "sure thing" it's advertised as.
A case study
Consider, for example, the cases of Emdeon
Are they small? Fairly. Emdeon is capitalized at $1.4 billion; lululemon at $2.0 billion.
Are they led by dedicated founders? No and yes. While Emdeon has some insider ownership and a number of major shareholders, the company doesn't fit the classic model. Lululemon founder Dennis Wilson, on the other hand, serves as the company's chairman and chief product designer and owns 7% of the company.
Are they fiscally conservative? While both companies are profitable and cash-flow positive, lululemon needs to keep an eye on its SG&A expenses, and Emdeon has had some lumpy operating performance.
Do they have wide market opportunities? That answer gets a little cloudy. While both companies' products have received good reviews, both also face significant competition going forward. Furthermore, in order to keep growing, both will encounter more and more competition. Lululemon, for example, will have to go head-to-head with behemoths like Nike.
The Foolish final word
I'm not here to be negative about either Emdeon or lululemon. Both have positive traits that could make them good investments.
As you set about analyzing companies you think could be "the next [fill in the blank]," remember the four-step framework. This is one of the ways we start our research process for our Motley Fool Hidden Gems small-cap investing service. Again, we believe that tomorrow's big winners will start off:
1. Small
2. Led by a dedicated founder(s)
3. Fiscally conservative
4. Profiting from a wide market opportunity
If you'd like to take a look at the companies we've found that meet the four criteria mentioned above, click here to join Hidden Gems free for 30 days.
Already a member of Hidden Gems? Log in at the top of this page.
This article was originally published Oct. 19, 2006. It has been updated.
Tim Hanson does not own shares of any company mentioned. The Fool owns shares of Costco. Costco is both a Motley Fool Stock Advisor and a Motley Fool Inside Value recommendation. The Fool's disclosure policy assures you that no stocks were harmed in the penning of this article.
