To Be Winners Like Amazon, Stocks Should Pass Four Tests

The New York Times reports that American International Group (AIG) executives balked at taking shares of their company as compensation in 2009. In their negotiations with comp cop Kenneth Feinberg, the anonymous executives took that position because they believed that AIG shares -- then trading at $40 a share -- were in fact worthless. This raises an interesting question: Are all stocks duds or just AIG shares?%%DynaPub-Enhancement class="enhancement contentType-HTML Content fragmentId-1 payloadId-61603 alignment-right size-small"%% AIG executives wanted to keep getting real money -- e.g, cash -- rather than AIG stock, which they believed would be as good as getting a handful of dust. These are likely many of the same AIG executives who got $165 million in cash bonuses in 2009 for managing their company into a ditch -- $99 billion in 2008 losses and a $182 billion bailout. And they're on track to get $200 million in bonuses in 2010 courtesy of American taxpayers who own 79.9% of AIG common shares.

Need To Make AIG's Net Worth Positive

If the people who run AIG believe that its stock is worthless -- and the Times reports that many analysts have concluded that its equity will never exceed the value of its obligations -- then those executives should be replaced by ones who can craft and execute a strategy to make AIG's net worth positive so those shares will become valuable.

The AIG situation made me wonder whether all stocks are duds. After all, as Bill Gross told me in February 2009, common stock is at the bottom of the liquidation hierarchy -- meaning that when a bankrupt company's assets are sold, there is little left over for the common stock investors after lenders, bondholders and preferred shareholders get their cut of the proceeds. (It's an interesting point, but Gross was wrong last year -- from the day of my post, the S&P 500 rose 48%).

Furthermore, the average investor has suffered major pain from investing in stocks. As I posted, in the last decade, the S&P 500 lost 23%, the Dow Jones Industrials fell 8.25%, and the NASDAQ plunged 40%. Overall, this cost investors $2.5 trillion in lost wealth and they are now keeping $3.2 trillion in money-market funds earning next to nothing just to keep from losing more.

Why Are We Still Buying Stocks?

And yet many people still buy stocks. Why? Over the long run, stocks outperform all other classes of investments -- according to Wharton professor Jeremy Seigel. And then there's Warren Buffett who started investing in common stocks with $174,000 around 54 years ago and did well. He was worth $37 billion in March 2009. That's despite having watched his Berkshire Hathaway (BRK.A) shares tumble 48% from their 2007 peak during 2008, a possible decline about which I posted in December 2007.

The basic problem here is that the average investor lacks Buffett's stock-picking ability. In 1956, when Buffett got started, it would have been great to have invested with him. But since he is now closer to the end of his investing career, there is little chance for that average investor to profit much from Buffett's skills by buying Berkshire shares, which still trade 34% below their peak.

But hope for stocks remains. Even during the last awful decade for stocks, some individual issues did very well. One example, is Amazon (AMZN), which ended the decade at a record high. But how is the average investor to separate the few winners from the many losers? The simple answer is that it is impossible because nobody, except perhaps Buffett, can figure out consistently how to win with stocks.

Stocks Should Pass Four Tests

But comparing AIG and Amazon helps highlight four useful criteria for selecting stocks. People should consider investing in the few stocks that pass four tests:
  • The CEO and other top executives have their net worth tied up in the public shares
  • The company participates in a large, rapidly growing industry
  • The company is the market-share leader and has the skills needed to maintain that lead
  • The company usually beats earnings expectations and raises revenue and profit guidance
It may be worthwhile for you to consider whether the three companies I mentioned in this post on Friday pass these tests.

My conclusion about stocks in general is that some are a duds -- particularly those where top executives don't want to own the shares; most -- while pretty well managed -- are not good long-term investments; and a handful are good stocks for the long run.

The problem for the average investor remains finding those few.

Peter Cohan owns AIG shares and has no financial interest in the other securities mentioned.
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