Apart from those investors committed to indexing strategies, everybody is on the hunt for market-beating stocks. After all, if you do not expect a stock to beat the market, why take the risk that goes with individual stock selection? While investors should always be suspicious of any advice claiming to offer easy strategies to spot market-beating stocks, long-term high performers do seem to share certain traits. (For related reading, also take a look at How To Make A Winning Long-Term Stock Pick.)
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A Short-Term Warning
Before talking about how to spot market-beating stocks, a word of caution is in order. The motivating principle of this column is to find stocks that beat the market for the long term. In the short term (18 months or less), almost anything can "work" and outperformance is based largely on investor enthusiasm and stock market momentum.
Unfortunately, that system does not hold up so well over time - last year's winners tend to be next year's losers as the enthusiasm fades, momentum investors move on and high valuations are no longer ignored by the market. Consider the words of Warren Buffett who has said (perhaps quoting his mentor Ben Graham) that, "in the short-run the market is a voting machine; in the long run, it's a weighing machine." With that in mind, here are the hallmarks of a market-beating stock.
1. Excess Economic Profits
Ultimately, the companies that win over the long term are the companies that follow a deceptively simple formula. These companies earn economic profits in excess of their cost of capital. To some extent, though, this is a tautology that is not all that helpful. After all, companies do not report their economic profits (they report accounting profits, as determined by GAAP rules) and no two analysts will ever agree completely on the proper calculation of the cost of capital.
2. Strong Returns on Invested Capital (ROIC)
Return on invested capital is a pretty handy substitute for separating out those companies that are earning the sort of returns that lead to long-term success. Return on capital divides some measure of the company's profitability (net income, EBITDA, NOPAT, et al) by the company's capital base (debt and equity).
In simple terms, this number tells an investor what they would earn if they supplied all of the company's capital as a sole owner - if a business produces a 10% ROIC and you capitalized it to the extent of $100 million, you could expect to earn $10 million from it each year. Likewise, an investor can compare a company's ROIC to some estimate of its cost of capital and determine whether it is earning a surplus on that capital - which, again, is ultimately the most important factor in long-term success.
Even if an investor is not comfortable estimating that cost of capital, ROIC can be handy. Take the average return of the stock market - generally reported as around 8-10% a year - and compare that to the ROIC. If the company is earning a return on its capital in excess of market returns, it is likely a strong candidate to be a long-term winner. (Learn more about ROIC in Find Quality Investments With ROIC.)
3. Healthy Margins
Margins are often another bellwether to a winning stock. Strong margins reflect both good front-end operations, as in a product that is attractive enough to customers that they will pay up for it, and good back-end performance, in that the company can produce and distribute the product profitability. While there are some long-term winners with single-digit margins, there are not many, so investors should seek out companies that have both double-digit margins and margins in excess of their industry average.
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4. Appealing Markets
It is tough to find great properties in terrible neighborhoods, so investors need to focus on companies in attractive markets. What is an attractive market? Investors should look for markets that are growing and have profitable participants. Investors should also seek to avoid products/markets that are mere commodities. Long-term success rests upon offering a differentiated product that customers are willing to pay for over and over again, and commodities simply do not offer that opportunity.
5. Good-to-Great Management
Last and by no means least is management. More than anything else, the quality of management determines the quality of a company and its stock. Good managers are efficient allocators of capital, savvy stewards of assets and provide vision, leadership and integrity. Ultimately it is management that separates the winners and losers. There is no idea so good that a bad manager cannot screw it up, nor is there any market so intrinsically bad that a good management team cannot develop a business plan that can enrich patient shareholders.
For better or worse, though, assessing management is something of a circular argument. Good managers lead their companies to long-term revenue growth by identifying good markets and developing good products, to strong margins by offering differentiated products and producing them efficiently, and to high ROICs by efficiently using capital. Good managers will also stand out, though, for not being piggish when it comes to their own compensation, and for openly discussing both their achievements and their failures when addressing investors and analysts. (For related information, see Evaluating A Company's Management.)
Final Step - Combine with Low Valuation
Investors who follow those guidelines should have an above-average chance of uncovering long-term winning stocks. There is one final step, though, that investors should keep in mind. Valuation does not precisely determine long-term market success, but it absolutely plays an important role. After all, buying the "right" stock at the "wrong" price can take years to work out favorably.
What makes a stock "cheap" is a separate discussion in its own right. The good news, though, is that whether an investor uses discounted cash flow, EV/EBITDA, price-to-book or PEG does not seem to make a huge difference. If investors focus on finding companies that produce high ROIC and couple that with some valuation discipline, then long-term market-beating returns are definitely possible. (For further reading, check out The Value Investor's Handbook.)