Let's get one thing straight: To get incredibly rich in the stock market with a buy-and-hold strategy, you need to own the best companies. There's no way around it. But how can you determine what the truly best companies are?
I'm here to tell you that there are five simple characteristics shared by every single one of the best companies on Earth. If you can identify these five traits and have the discipline to invest at the right times (and perhaps sell if things change), you'll never have to worry about money again.
The fab five
Without further ado, the five traits are:
- Creation of high utility for customers
- Something special
- High rate of innovation
- Excellent managers
- Efficient operations
It sounds like a basic list, but when you come down to it, business is basic -- the production of a good or service for a customer. The quality of a company depends on how useful its product is, how defendable its markets are, and how fast it can produce new and better products. Solid management and cost-effectiveness are musts as well.
The fab five, one by one
Let's examine each trait and look at some examples.
"Creation of high utility for customers" means producing a good or service that customers value very highly, or literally can't live without. A perfect example is Rockwell Collins, which produces navigation and landing guidance systems for airplanes. I don't know about you, but I'd say any piece of equipment that allows a plane to land creates a lot of value for airlines and passengers. Another one closer to home is McCormick (NYSE:MKC), the spice maker that millions of cooks rely on to flavor their meals.
Contrast this with footwear and apparel providers like Deckers Outdoor (NASDAQ:DECK) or American Eagle Outfitters (NYSE:AEO) that face oodles of competition for the customer's retail dollar, and you'll start to see what I mean. Creation of unique value typically leads to repeat purchases.
"Something special" is intentionally broad because this trait comes in many forms. The company needs this little bit extra to maintain its advantage and inhibit competition. It could be a patent, a secret formula like that of Fortune Brands' (NYSE:FO) Jim Beam whiskey, or a valuable network, where more advantages flow to the company the bigger the network gets. A special manufacturing process or distribution network that allows a company to be the lowest cost provider could be a significant advantage. For example, cutting out the middleman gives Geico a low-cost advantage in providing car and other vehicle insurance that's tough for competitors to match.
"High rate of innovation" relates to how a business must constantly improve to stay ahead of its rivals. The technology sector is full of fast-paced innovation, and staying ahead of the curve isn't easy. An excellent example is the now-ubiquitous iPod. I recently dug my first iPod out of a box and was amazed at how clunky it is. Plus, it only has 10 gigabytes, whereas the new models have 120 gigabytes -- 12 times as much, and, I'm embarrassed to say, more than my home laptop. Almost all businesses have to innovate to survive and grow, so an ability to do this effectively, as with the iPod, or even in the case of Procter & Gamble (NYSE:PG) in home supplies, is crucial.
"Excellent managers" is self-explanatory. A company is only as good as its assets and the people using them. General Electric is a great example; it spends an estimated $800 million every year on educating its employees and managers. As a result, GE enjoys dominant market positions and boasts highly regarded managers, who rank among the most sought-after executives to lead other companies. Others, like the leadership at truck-maker Paccar (NYSE:PCAR), are noted for both their managerial prowess as well as their capital allocation skills and are immensely valuable to shareholders of that company.
Finally, the company needs to "operate efficiently." This enables the business to earn enough money to focus on the first three traits. The pioneer of efficient manufacturing is Toyota, which was the early adopter of lean manufacturing and kaizen techniques. Other companies like Cemex (NYSE:CX) have devised indigenous techniques like state of the art fleet management to lower costs to provide local advantages within their competitive regions.
Start investing
That's it. The five characteristics of each truly brilliant business on this planet. They are self-evident, yet ever so difficult to obtain and hold.
I encourage you to think about every company in this light. How much value does it really create for the customer? Can it do something no one else can do? Is it well-managed? These questions are simple, but the implications are very deep, and if you can check off even four out of five boxes, you'll likely have a winner on your hands.
This is all we do at Motley Fool Inside Value -- focus on identifying companies with these characteristics, and pick our spots to invest in them. We're extremely pleased that many of the world's best businesses are on sale now.
Good luck investing! If you need help, consider taking a 30-day guest pass to Inside Value. You'll get all of our recommendations, including our five best ideas for new money now, as well as a discounted cash flow calculator you can use to evaluate companies on your own. Click here to get started.
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This article was first published March 1, 2009. It has been updated.
Fool analyst Andrew Sullivan owns Cemex shares but has no financial position in any other of the stocks mentioned in this article. Rockwell Collins is a Motley Fool Inside Value pick. Cemex, Fortune Brands, and Paccar are Stock Advisor selections. McCormick and Procter & Gamble are Income Investor selections. Cemex is a Global Gains recommendation. The Motley Fool owns shares of Procter & Gamble and Cemex and has a disclosure policy.
