Saturday, April 4, 2015

Signs of a Perfect Stock

Peter Lynch's chapter in One Up on Wall Street describing the signs of a "perfect stock" was one of the most influential to my early investing career because it steered my attention away from the water cooler stocks I'd typically hear about and toward underfollowed, niche companies that operated in decidedly unglamorous industries.

As I've developed my own style of investing, I've come up with my own list of company traits that I like to look for when researching a new stock. I have yet to find a company that checks off all ten boxes, granted, but if the company possesses at least two attributes, it makes me sit up and take notice.

1. Management and directors have significant skin in the game. One of the first things I check into when researching a company is how much stock management and the board members own. With smaller companies, I like to see executives and directors as a group owning at least 5% of the company, as they'll will be less likely to take undue risks with shareholder capital and more likely to think like owners because they are in fact owners. With larger companies where high-percentage ownership is less realistic, insiders should still own enough where the stock's long-term performance has a material impact on their own net worth.

I particularly like to see companies, like Sun Hydraulics (SNHY), pay their board members solely in stock grants with long-term vesting as this increases the likelihood that the board's interests will be aligned with those of long-term shareholders.

2. Its employee turnover is well-below industry average. Having to frequently train new employees is not only negative on the income statement, but the company also loses valuable institutional memory with the departure of each employee. One of the many reasons that Costco (COST) has stood apart from other retailers is that its employee turnover (6% in 2014) is far below the retail industry average. Diamond Hill Investment Group (DHIL) has had zero turnover (at least as of 2013) in its equity portfolio manager and research analyst group since the firm was founded.

3. It's headquartered in a smaller town. This may seem trivial, but I like to see companies based far outside of major financial centers as I think they're more likely to fly under Wall Street's radar, can afford to take a longer-term perspective, and have employees with a better work/life balance (less traffic, affordable housing, etc.).

4. It has a great corporate culture that reinforces its competitive advantages. See: Don't Overlook This Factor in Your Research Process

5. It makes products that can't be (easily) disrupted by technology. If a start-up in Silicon Valley or a teenager in her garage is looking for ways to challenge a company's business model, eventually they'll find a way. That's why I prefer to own companies that make products that aren't likely to change or be disrupted anytime soon (knock on wood), like Douglas Dynamics' (PLOW) snow plows or WD-40's (WDFC) eponymous oil-based spray.

6. It pays a regular dividend and pays special dividends in good years. After particularly strong years, well-run companies often find themselves flush with cash. While this is a good problem to have, it can become a bad problem if management misallocates the capital by pursuing growth-for-growth's sake acquisitions and overpaying for them. Paying special dividends shrinks management's sand box and allows them to focus on only reallocating the capital that can earn high long-term returns.

7. It approaches buybacks opportunistically. Most companies I've come across approach buybacks as a way to return excess cash to shareholders without regard to the value of the shares they're buying back. As such, I like to see a company with a cogent and disciplined buyback strategy like U.K. retailer, Next (NXT.L). Such companies should, over time, create value for long-term shareholders.

8. It prefers to grow organically rather than through aggressive acquisitions. A company that's willing to start from scratch in new markets and build the business slowly and in the manner they want shows me that they're willing to take a long-term approach.

9. It communicates plainly with shareholders. See: 5 Signs of a Good Annual Report

10. It has a meaningful recurring revenue stream. One of the best investments I've made was in a healthcare equipment company called Kinetic Concepts, also known as KCI, which was acquired in 2011. KCI makes negative-pressure wound therapy equipment for healing difficult-to-treat wounds, and the great thing about their business model was they lease or sell the equipment and sell the one-use dressing kits that needed to be changed out during treatment. The disposable product sales provided KCI with a steady recurring revenue stream that gave me added confidence to buy the stock in November 2008 at a time when the market in turmoil.

What company attributes do you look for? Let me know on Twitter @toddwenning or in the comments section below.

*I own shares of Douglas Dynamics, Sun Hydraulics, Diamond Hill, and WD-40. A list of my current holdings can be found here

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