The Perfect Stock

When it comes to risk, it's true that no stock is "perfect." Every single one of them goes up and down. Shareholders of Titanium ATP Oil & Gas (Nasdaq: ATPG) and Trina Solar (NYSE: TSL) are very happy with 100% gains over the past year, but it's almost certain their companies -- more than twice as volatile as the market -- will drop 25% or more at some point in the future. That's not a knock on the companies, that's just the life of a volatile growth stock.

With that huge disclaimer out of the way, let's talk about what would make for a perfect stock -- at least as perfect as possible. Some might lean toward a stable and safe large-cap blue chip like Johnson & Johnson (NYSE: JNJ), which I personally own because of the competitive advantages offered by its name-brand products, amazing dividend history, and long-term outperformance. J&J and its kind will rarely cause you to lose sleep at night. Others may consider perfection to be a nerve-racking, rocketing small-cap multibagger -- the kind Tim Hanson wrote about in "The Market's 10 Best Stocks."

Instead, I see the perfect stock as somewhere in between. I look for companies with market caps of less than $3 billion, so that the stock still has plenty of room to reach 10-bagger status. I also require some degree of stability and predictability, with little chance of a bankruptcy that would torpedo my portfolio.

For example
When I first wrote about this concept in 2006, I said my perfect stock would look just like Middleby -- the commercial oven maker and supplier to fast-food stars such as McDonald's and Wendy's. (Middleby is not perfect anymore, however; more on that later.)

I hadn't heard of this company until Tom Gardner recommended it in Motley Fool Hidden Gems in 2003. After watching it quadruple in value, I studied it closely and found three main traits that propelled it skyward:

1. Great leadership. Selim Bassoul rose through the company ranks, serving as president and chief operating officer of various subsidiaries before his promotion to CEO in 2001. He brought focus and business savvy to the top post, along with a strong emphasis on higher margins and consistent earnings growth.
2. Focus, especially on strong global trends. Bassoul's valuable experience led him to make a gutsy decision to abandon the idea of serving the entire kitchen. He jettisoned such products as coolers and refrigerated deli cases to concentrate solely on ovens and toasters. With all of its efforts thrown behind these high-margin and patentable products, Middleby has profited handsomely from the strong global trend of eating outside the home.
3. High insider ownership. Our preference for companies with high levels of insider ownership is well-documented. More managers and directors with significant stakes in the business mean more decision-makers whose interests are aligned with ours as individual shareholders. At the time, 25% of Middleby was owned by insiders.

Toss in the fact that it was an obscure company in a boring industry -- something legendary investor Peter Lynch loved -- and you can see why it was loaded with potential.

Here are some other companies with similar traits -- well worth further research:

Data from Capital IQ.

Any company with these traits selling at a reasonable valuation should garner serious consideration for your investment dollars.

Fast-forward
But alas, perfection does not always last -- and sadly, that was the case with Middleby. Over the past couple of years, our Hidden Gems analysts have been questioning what seemed like excessive compensation for Bassoul. The issue did not go away, and it really came to a head in recent months. Management's incentive plan has embarrassingly low hurdles to trigger bonus compensation, such as achieving return on equity levels of 10% to 12% over the next couple of years -- about half of what the company attained over the last 12 months. It's probably no coincidence that insider ownership has fallen from 25% to less than 11%

Hidden Gems recently sold Middleby off its scorecard, locking in gains of 400% from the original recommendation. As Gems co-advisor Seth Jayson wrote in the sell report, big paydays, low hurdles, and a compliant board sealed the deal: "[We're] convinced that the board is at best shirking its oversight duty and at worst simply rubber-stamping and allowing Bassoul to write his own paycheck."

This illustrates a huge benefit that comes from following a stock closely for years. The story is shifting at Middleby, and we're more than happy to lock in big gains and wish best of luck to those who continue to hold.

Don't sweat it
There are still a handful of companies in the Hidden Gems portfolio that fit my "perfect stock" criteria. One of them is Under Armour, the sportswear company that keeps multi-million-dollar athletes -- and weekend warriors like you and me -- exercising in comfort. Besides incredible growth rates and a strong balance sheet, see if you recognize the similarities to what we found in Middleby many years ago. From the buy report:

[Under Armour] has that commercial competitiveness peculiar to upstart Davids facing down industry Goliaths (such as Nike). Founder and CEO Kevin Plank is laser-focused on making the company succeed. He owns a considerable chunk of the company, and, in fact, draws a pittance in other compensation because his future net worth depends entirely on the performance of Under Armour's stock.

Our team searches for such standouts every day in Hidden Gems. And so far, we've been well rewarded, easily beating the market since the newsletter started in 2003. If you'd like to check out all of our small-cap recommendations, including the eight Buy First stocks, we're offering a special 30-day free trial. Click here to give it a whirl.

This article was originally published March 26, 2010. It has been updated.

Rex Moore contributes the Foolish 8 screens to Hidden Gems. Of the companies mentioned in this article, he owns shares of Johnson & Johnson. Mercadolibre and Under Armour are Motley Fool Rule Breakers selections. Morningstar is a Stock Advisor pick. China Green Agriculture is a Global Gains recommendation. Johnson & Johnson is an Income Investor recommendation. Motley Fool Options has recommended a buy calls position on Johnson & Johnson. The Fool owns shares of China Green Agriculture, Morningstar, and Under Armour, and has a disclosure policy.