What Makes a Perfect Stock?

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Over the past several years, I've looked at hundreds of different companies in a quest to find stocks with the ideal combination of favorable attributes.

Yet while few stocks have everything one might want to see in an investment, knowing the most desirable traits of great stocks can guide you in making choices for your own portfolio.

Here's a guide to what to look for in a stock to decide whether it's perfect for you.

Growth: The Key to Future Value

Stagnant businesses without any future prospects may be profitable, but they can't produce the strong returns that stock investors rely on. Therefore, for a business to thrive, it needs to grow.

Healthy businesses focus on increasing the sales they make to their customers year in and year out, finding new ways to capture more revenue from their existing clientele, and offering innovative high-value goods and services to bring new customers in the door.

The best growth stocks are able to grow sales at a 15 percent annual clip consistently over a long period of time. Although year-to-year blips may temporarily depress growth, keeping sales up over the long haul ensures that companies remain on the cutting edge of their industries and aren't simply coasting on their past success.

Profitability: Turning Sales Into Cash

As important as sales growth is, a company won't survive if its costs are greater than what it gets paid for its products. Businesses need to control their costs and allow as much of their sales to fall through to the bottom line as net income.

To measure exactly how much of every dollar of revenue becomes profit, you can look at various margin figures.
  • Gross margins tell you what percentage of sales revenue is left after subtracting the direct costs of producing goods or providing services.
  • Net margins deduct the other expenses of doing business, such as overhead, marketing and advertising, and interest expense.
Gross margins above 35 percent and net margins of 15 percent or more indicate that a company is working hard to squeeze as much profit as possible from its business.

In some industries, though, these numbers aren't realistic. For instance, in the grocery business, much narrower margins exist because the goods are commodities, with prices subject to market forces rather than being under the grocer's control. But when you compare a stock to its industry peers, high margins indicate a superior company.

Another measure of profitability is return on equity, which measures how much profit a company produces in comparison to the shareholder equity within the company. Returns on equity of 15 percent or more indicate that a company is finding lucrative opportunities to invest in its business that create substantial profits. In contrast, lower or negative returns on equity suggest that companies might be better off simply returning shareholder capital to investors in the form of dividends.

Balance Sheet: Being Responsible With Shareholder Value

As a stock investor, you benefit the most from increases in a company's overall value. But if the company has other stakeholders -- such as bondholders or banks that lend it money -- then it can't focus solely on doing whatever it takes to make your shares worth as much as possible.

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In certain cases, companies have to take actions that harm their shareholders in order to fulfill their obligations to their creditors.

To avoid those conflicts, the best stocks keep control of their debt. It's not necessary to avoid debt entirely, but keeping it down to manageable levels of less than 50 percent of shareholder equity will help ensure that debt doesn't create difficult situations for stock investors.

Valuation: The Right Stock at the Right Price

A great company can be a terrible investment if you have to overpay for it. Countless companies have had amazing growth prospects only to collapse under the weight of their own business models, and investors who get caught up in stock-market hype rather than business fundamentals often end up overpaying for hot stocks.

Different investors have different thresholds for valuations based on earnings, but looking for a price-to-earnings ratio of 20 or less is a very reasonable benchmark. The best value stocks often sport earnings multiples well below 20, but using a somewhat higher standard leaves room for higher-growth companies that command more respect from investors.

Dividends: How a Stock Rewards You

Finally, the best stocks not only pay solid dividends but continue to reward shareholders through dividend increases over time. In the end, the cash you get in dividends is the most tangible sign of a stock being a good investment.

Looking for stocks with dividend yields at or above the 2 percent level corresponds well to the average dividend for the broader market. Seeking a record of 10 percent annual dividend growth weeds out stagnant stocks with poor growth prospects.

Don't Settle For Less Than the Best

Finding stocks that have all of these traits is a tall order. But if you can identify which stocks excel at delivering these desirable attributes to their shareholders, it can give you a useful starting point in deciding whether a stock belongs in your portfolio.

What Makes a Perfect Stock?
Warning stat: The price of college textbooks is up over 800 percent since 1978.

What the experts say: "The cost of college textbooks has been rising at almost twice the rate of general CPI inflation for at least the last 30 years," according to Mark J. Perry, American Enterprise Institute. "As Glenn Reynolds reminds us, 'a process that cannot go on forever, won't,' and the college textbook bubble is certainly one of those processes."
 

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Warning stat: First tier cities Beijing and Guangzhou saw home prices rise 3.1 percent in February, the biggest jumps in the country. Meanwhile, entire towns will go up in China with no inhabitants. These are China's notorious "ghost cities."

What the experts say: "There are obvious bubbles in the property market, and it is possible it will get out of control and crack," according to Wang Shi, chairman of China's largest developer.
 

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Warning stat: The "crypto currency" now trades at $63 -- double what it was at the beginning of March.

What the experts say: "In hindsight, the people who bid the price of Bitcoins up to $30 in 2011 may not have been so crazy after all. It just took the broader market, including me, a couple of years to catch up with them," according to Ars Technica's Timothy B. Lee.

Warning stat: Investors recently bid a record $3.16 for each dollar of the $2.011 trillion in bonds the U.S. government auctioned in 2012, Bloomberg says.

What the experts say: "Long-term interest rates are now unsustainably low, implying bubbles in the prices of bonds and other securities," warns economist Martin Feldstein. "When interest rates rise, as they surely will, the bubbles will burst, the prices of those securities will fall, and anyone holding them will be hurt."

PHOTO: Wikipedia

 

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Warning stat: Between December 2012 and February 20130 -- when Congress proposed a new assault weapons ban -- Colorado background checks soared 102 percent. Gun sales in Maryland between December and January totaled 68 percent of all the state's gun sales in 2010.

What the experts say: "We wouldn't see the demand increase if there weren't a ban, so we're getting a bubble that's caused by that demand increase due to the ban," according to Mac Clouse, Denver University finance professor.
 

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Warning stat: American farmland prices continue to grow at a blazing hot double-digit rate. An industry group recently forecast that values could surge 15 percent to 20 percent in 2013.

What the experts say: "It doesn't have all the hallmarks of a bubble," according to Robert Shiller. "One of them is most people have never heard of it. In my view of a bubble, it's something that gets people excited. Well, some people are excited, but most people don't even know about it."
 

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Warning stat: January home prices surged 23 percent in Phoenix and 17.5 percent in San Francisco, according to Case-Shiller.

What the experts say: "The real question in my mind is, 'Are we possibly off to the races again?'" asked economist Robert Shiller. "I think in cities like Phoenix and San Francisco, we might be seeing something pretty big developing. People there are very speculative-minded."
 

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Warning stat: Casino magnate Steve Wynn bought Picasso's "La Reve" in 1997 for $48 million. In March, he reportedly sold it to hedge fund manager Steve Cohen for $155 million.

What the experts say: "Art is in an insane bubble with many classic pieces going from $35 to $50 million and up," warned Dow Theorist Richard Russell.
 

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Warning stat: Gold has gone from around $1,000 per ounce in 2009 to around $1,600 today.

What the experts say: George Soros called gold the "ultimate asset bubble" in 2010 when it was priced at $1,275. We're obviously still above those levels.
 

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Warning stat: Health care spending has grown 2.5 times faster than incomes over the past 30 years.

What the experts say: "The health care system in the U.S. reminds us somewhat ominously of the bubble in housing finance, a 'public/private partnership,'" says Citi's Steve Wieting. "Housing consumption still receives strong tax preferences, as does health insurance (reflecting underlying health care consumption). Most aptly, prior to quasi-nationalization, housing GSEs earned private profits from public subsidies for housing, as do U.S. health care providers."
 

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Warning stat: Europe stabilized after ECB president Mario Draghi said, "Within our mandate, the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough."

What the experts say: "To us the key word about the post summer 2012 Euro Area asset boom is that most of it is a bubble, and one which will burst at a time of its own choosing, even though we concede that ample liquidity can often keep bubbles afloat for a long time," warns Citi Chief Economist Willem Buiter.
 

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Warning stat: Prices are up 47 percent year-over-year, and are sitting at an 8.5 year high of $432 per 1,000 board fee.

What the experts say: "Signs of a housing bubble in the world's most populous nation may force the Chinese government to take measures to 'draw air' out of the rising housing market and to clamp down on construction lending, which would likely put a significant dent in the demand for building materials such as Lumber and Copper," according to Mike Zarembski, OptionsXpress.
 

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Warning stat: College tuition is up around 1,115 percent since 1978.
What the experts say: Jeff Gundlach notes that not only have wages not increased commensurate with tuition inflation, wages have actually been falling. "What have all these soaring tuition costs got you?" asked Gundlach rhetorically.
 

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Warning stat: Craft beer production surged 15 percent year-over-year in 2012.

What the experts say: Boston Beer Co. founder Jim Koch says most stores have reached their limit for carrying new breweries, and that too many breweries are making similar beers without adding anything to the market.
 

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Warning stat: Canadian home prices mirrored the U.S. housing rally. However, Canadian prices never fell. A recent Canadian Housing Affordability study says the country's home market is 10 percent overvalued.

What the experts say: "I worry that what is happening in Canada is kind of a slow-motion version of what happened in the U.S," said Robert Shiller.
 

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Warning stat: The S&P 500 recently closed at an all-time high, up 135 percent from its March 2009 low.

What the experts say: "What we find is that Bernanke does not have nearly as great a track record on inflation as he thinks he has. Greenspan could not see that the housing market was an inflated bubble. Evidently Bernanke cannot see that the stock market is an inflated bubble."
 

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