The 100 Best Stocks You Can Buy 2012 Part 3

What Makes a Best Stock Best?.

So now we get down to bra.s.s tacks. Now, the rubber meets the road. Just exactly what is it that separates the wheat from the chaff, the cream from the milk, the great from the merely good? What is it that defines excellencesustainable excellenceamong companies? That's been a topic of considerable debate for years, and with all the study that's gone into it, it's amazing that n.o.body has. .h.i.t upon a single formula for deciphering undeniable excellence in a company.

That's largely because it isn't as scientific as most of us would like or expect it to be. It defies mathematical formulas. Take the square of net profits, multiply by the cosine of the debt-to-equity ratio, add the square root of the revenue-per-employee count, and what do you get? Some nice numbers, but not a clear picture of how it works together or how a company will sell its products to customers and prosper going forward.

Business and financial a.n.a.lysts study such fundamentals, as well they should. Fundamentals such as profitability, productivity, and a.s.set efficiency tell us how well a company has done and by proxy, how well it is managed, and how well it has done in the marketplace. Fundamentals are about what the company has already achieved, and where it stands right now, and if a company's current fundamentals are a mess, stop right now, there isn't much point in going any farther.

In most cases, what really separates the great from the good is the intangibles, the "soft" factorsof market position, market acceptance, customer "love" of a company's products, its management, its aurathat really make the difference. These features create compet.i.tive advantage, or "distinctive competence" as an economist would put it, that cannot be valued. Furthermore, and most importantly, they are more about what a company is set up to achieve in the future.

Buffett put it best: Give me $100 billion, and I could start a company. But I could never create another Coca-Cola.

What does that mean? It means that c.o.ke has already established a worldwide brand cachet, the distribution channels, customer knowledge, and product development expertise that cannot be duplicated at any cost. When companies have compet.i.tive advantages that cannot be duplicated at any cost, they have an enduring grip on their markets. They can charge more for their products. They have a "moat" that insulates them from compet.i.tion, or makes it much more expensive for compet.i.tors to partic.i.p.ate. They're perceived by loyal customers as being top-line products worth paying more for.

A company with exceptional intangibles can control price and in many cases, can control its costs.

A GREAT EXPERIENCE. BUT IS IT A GOOD INVESTMENT?.

One way to learn a principle is to examine what happens when the principle does not apply. One industry where most of the fundamentals and almost all the intangibles work against it is the airline industry. Airlines cannot control price, because of compet.i.tion, and because an airplane trip is an airplane trip. Aside from serving different snacks or offering better schedules, there is little an airline can do to differentiate their product, and almost nothing they can do to justify charging a higher price. Further, they have no control over costslike fuel prices, union contracts, and airport landing fees. While some airlines offer good service, there is almost nothing they can do to distinguish themselves as excellent companies or excellent investments.

With these ills in mind, for two years we've resisted the temptation to put Southwest, one of the most efficient, customer-focused, and best-managed businesses we know of, on our 100 Best list. Great company, bad industry. This year we decided to add them to the list anyway, as their business model and the continued floundering of their compet.i.tors should give them an edge that we feel investors may finally be willing to reward. We also think they've been so good for so long that many of their customers will be willing to pay somewhat higher prices to stick with their offering. Indeed, there's recent evidence that their average revenue per ticket has risen substantially. They've also introduced some effective revenue enhancers, like priority check-in, a much more customer-friendly revenue booster than the annoying baggage fees charged by other carriers. These guys still get it, and we feel that their approach will put them farther ahead of the compet.i.tion and allow them to overcome some of the industry's worst ills. Fasten your seat belt....

Strategic Fundamentals.

Without any further ado, let's examine a list of "strategic fundamentals" that define, or keep score of, a company's success. This list can be used as a checklist, although it's hard to find a company that shows excellence in all of these areas.

Are Gross and Operating Profit Margins Growing?

We like profitable companies; who doesn't? But what really counts is the size of the margin and especially the growth. If a company has a gross margin (sales minus costs of goods sold) exceeding that of its compet.i.tors, that shows that it's doing something right, probably with its customers and/or with its costs. But compet.i.tive a.n.a.lysis is elusive; there is no dependable source of "industry" gross margins, and comparing compet.i.tors can be difficult because no two companies are exactly alike; it's easy to mix apples and oranges.

We like to see what direction gross margin is moving inup or down. A growing gross margin also signals that the company is doing something right. That isn't perfect either; as the economy moved from boom to bust many excellent companies reported declines in gross and especially operating margins (sales cost of goods sold operating expenses) as they laid off workers and used less capacity. Still, in a steady state environment, it makes sense to favor companies with growing margins. In a declining market, companies that can protect their margins will come out ahead.

Does a Company Produce More Capital Than It Consumes?

Make no mistake about itwe like cash. And pure and simplewe like it when a company produces more cash than it consumes.

At the end of the day, cash generation is the simplest measure of whether a company is being successful, especially over the long term. Sure, if a company buys an airplane or opens a factory or a bunch of stores in a given quarter, it will be cash-flow negative. But that should be a temporary thing; over the long haul, it should produce, not consume cash. Companies that continually have to borrow or sell shares to raise enough cash to stay in business are on the wrong track.

So how do you determine this? You'll have to become familiar with the Statement of Cash Flows or equivalent in a company's financial reports. "Cash flow from operations" is usually positive and represents cash booked from sales less cost of goods sold, with adjustments for non-cash items like depreciation and for increases or decreases in working capital. In simple terms, it is the cash going into the cash register from the business.

"Cash used for investing purposes" or similar is a bit of a misnomer, and represents net cash used to "invest" in the businessusually for capital expenditures, but also for short-term non-cash investments like securities and a few other smaller items usually beyond scope. This figure is typically negative unless the company sells some part of its infrastructure. Over the long haul, cash generated from operations should well exceed cash used to invest in the business.

Companies in expansion mode may not show this surplus, and that's where "cash from financing activities" comes in. That's the cash generated from issuing debt or selling securitiesor paying off debt or repurchasing shares, if things are going well, and dividends are included here as well. Again, a successful company will produce more cashcapitalfrom the business than it consumes, just as a successful household does the same, or else it goes into debt. Smart investors track this surplus over time.

Are Expenses Under Control?

Again, just like your household, company expenses should be under control, and anything else, especially without explanation, is a yellow flag.

The best way to test this is to check whether the "Selling, General and Administrative" expenses (SG&A) are rising, and more to the point, rising faster than sales. If so, that's a yellow, not necessarily a red, flag, but if it continues, it suggests that something is out of control, and it will catch up with the company sooner or later. In the recent downturn, companies that were able to reduce their expenses to match revenue declines scored more points, too.

Is Non-Cash Working Capital Under Control?

Working capital is a hard concept to graspeven for small entrepreneurs who live with its ups and downs on a daily basis. Insufficient working capital is one of the biggest causes of death for small businesses, and working capital and especially changes in working capital can signal success or trouble.

Using a simplistic a.n.a.logy, working capital is the circulatory lifeblood of the business. Money comes in, money goes out; working capital is what circulates in the veins in between. In its purest sense, it is cash, receivables, and inventory, less short-term debts. It's what you own less what you owe aside from fixed a.s.sets like plant, stores, and equipment.

If receivables are increasing, that sounds like a good thingmore people owe you more money. But if receivables are rising and sales aren't, that suggests that people aren't paying their bills, or worse, the business has to finance more to achieve the same level of sales. Similarly, a rise in inventory without a rise in sales means that it costs the business more moneymore working capitalto do the same amount of business. That costs twice, because unless the firm is lucky, more inventory means more obsolescence and potentially more deep-discount sales or more write-offs down the road.

So a sharp investor will check to see that major working capital itemsreceivables and inventoryaren't growing faster than sales; indeed, a company that generates more sales with a decrease in working capital is becoming more productive.

Is Debt in Line with Business Growth?

Like many other "fundamentals" items, you can tear your hair out looking at debt figures and trying to decide whether they're in line with a.s.set levels, equity levels, and industry norms. A simpler test is to check and see whether long-term debt is increasing or decreasing, and in particular, whether it is increasing faster than business growth. Gold stars go to companies with little to no debt, and to companies able to grow without issuing mountains of long-term debt.

Is Earnings Growth Steady?

We enter the danger zone here, because the management of many companies have learned to "manage" earnings to provide a steady improvement, always "beating the street" by a penny or two. So stability is a good thing for all investors, and companies that can manage toward stability get extra points, and it's worth checking for, but with the proverbial grain of salt.

Still, a company that is able to manage its sales, earnings, cash flow, and debt levels more consistently than compet.i.tors, and perhaps more consistently than what would be suggested by the ups and downs of the economy is desirableor at least more desirable than the alternatives.

Is Return on Equity Steady or Growing?

Return on equity (ROE) is another of those hard-to-grasp concepts, and another measure subject to subjectivity in valuing a.s.sets and earnings. But at the end of the day, it's what all investors really seek, that is, returns on their capital investments.

And like many other figures derived from income statements and balance sheets, a pure number is hard to interpretdoes a 26.7 percent ROE mean, in itself, that a company is excellent? The figure sounds healthy, to be sureit's a heck of a lot better than investing your money in a CD or T-Bill. But because earnings and a.s.set values are subjective, it may not represent true success. In fact, a company can increase ROE simply by borrowing money (yes!) and investing it into the business, even if it isn't invested as productively as other previous funds were invested. The math is complicated; we won't go into it here.

So the true test of ROE success is to check whether it is steady or increasing. Increasingthat makes sense. Why steady? Because if a company makes profits in a previous period and reinvests them in the business, that amount of money becomes part of equity (retained earnings). If the company reinvests productively, it will produce more returns, and ROE will at least keep up. If the company can't reinvest those earnings productively, ROE will dropand perhaps it should be paying the earnings to you as dividends instead of investing them unproductively in the business. So if ROE is steady, the company still has good investments to make, and management is probably doing the right thing.

Does the Company Pay a Dividend?

Different people feel differently about dividends, and as we mentioned earlier, we're placing a greater emphasis on dividend-paying stocks this year. After all, save for the eventual sale of the company to someone else, a dividend is the only true cash that an investor will realize from buying a stock in a corporation, other than by selling the stock. And, at least in theory, investors should receive some compensation for their investments once in a while.

Yet, many companies don't pay dividends, or don't pay dividends that compete very effectively with fixed income yields. So why do investors put up with this? Because, in theory anyway, a company in a good business should be able to reinvest profits more effectively than the investor can (or else why would the investor have bought the company in the first place?). And, investors trust that reinvested profits will eventually bring the growth in company value that will be reflected in the share price, or eventual takeover or an eventual payment of a dividend or, better yet, growth in that dividend.

That's the theory, anyway. But there are still lots of companies that get away with paying no dividend at all. Can we tolerate this? Yes, if a company is really doing a great job with their retained profits, like Apple or Google. But we favor companies that offer at least something to their investors in the short term, some return on their hard-earned and faithfully committed capital. If nothing else, it keeps management teams honest, and shows that management understands that shareholder interests are up there somewhere on the list of priorities.

A dividend is a plus. Lack of a dividend isn't necessarily a showstopper, but it suggests a closer look. A dividend reductionand there were many in the past yearsuggests poor financial and operational health, because the dividend is usually the last thing to go, but in some cases, reflects management prudence and conservatism. Best question to ask yourself: Would you have reduced the dividend if you were running the company? And down the road, does the company bring back the dividend as times get better? A "no" to either of these questions is troubling.

Finally, dividend payouts should be examined over time. We've seen and included in our lists a number of companies that have steadily increased dividends, many for each of the eight previous years. We like this; it's just like getting an annual raise, and if you hold the stock long enough, the percentage return against your original investment can get quite large, even approaching 100 percent per year if the stock is held long enough and the dividend is raised persistently enough. Getting an ever-increasing dividend and owning a stock that has most likely appreciated because the dividend has increased is like having your cake and eating it too, a true favorite among investors.

ARE VALUATION RATIOS IN LINE?.

One of the most difficult tasks in investing is determining the true valueand per share valueof a company. If this were easy, you'd just determine a value, compare it to the price, and if the price were lower than the value, push the buy b.u.t.ton.

Professional investors try to determine what they call the "intrinsic value" of a company, which is usually the sum of all projected future cash flows of a company, discounted back to the present (remember, money received tomorrow is both less predictable and less valuable than money received now). They use complex math models, specifically, "discounted cash flow" or DCF models, to project, then discount, earnings flows. But those modelsespecially for the individual investordepend too much on the crystal-ball accuracy of earnings forecasts, and the so-called discount rate is a highly theoretical construct beyond the scope of most individual investors. DCF models require a lot of estimates and number crunching, especially if multiple scenarios are employed as they should be. They take more time than it's worth for the individual investor. If you're an inst.i.tutional investor buying multi-million-share stakes, we would conclude otherwise.

Valuation ratios are a shorthand way to determine if a stock price is acceptable relative to value. By far and away the most popular of these ratios is the so-called "price-to-earnings" (P/E) ratio, a measure of the stock price usually compared to "ttm," or trailing twelve months' earnings, but also sometimes compared to future earnings.

The P/E ratio correlates well to your expected return on an investment you might make in the company. For instance, if the P/E is 10, the price is ten times the past, or perhaps expected, annual earnings of the company. Take the reciprocal of that1 divided by 10and you get 0.10, or 10 percent. That's known as "earnings yield," the theoretical yield you'd get if all earnings were paid to you as dividends, as an owner. Ten percent is pretty healthy compared to returns on other investments, so a P/E of 10 suggests success.

But of course, the earnings may not be consistent or sustainable, or there may be substantial risk from factors intrinsic to the company, or there may be exogenous risk factors, like the total meltdown of the economy. The more risk, the more instability, the lower the expected P/E should be, for the earnings stream is less stable. If you think the earnings stream is solid and stable in the face of the risk, then the stock may be truly undervalued. Look for P/Es that 1) suggest strong earnings yield, and 2) are favorable compared to compet.i.tors and the industry.

Apart from P/E, the price-to-sales ratio (P/S), price-to-cash-flow (P/CF), and price-to-free-cash-flow (P/FCF) are often used as fundamental yardsticks. Like P/E, these measures also have some ambiguities, and it's best to think about them in real-world, entrepreneurial terms. Would you pay three times annual sales for a business and sleep well at night? Probably notunless its profit margins were exceptionally high. So if a P/S ratio is 3 or above, look out; and opt for a business with a P/S of 1 or less if you can. Similarly, the price-to-cash-flow ratios can be thought of as true return going into your pocket for your investment; is it enough? Is it enough given the risk? And about the difference between "cash flow" and "free cash flow"? The difference is mostly cash laid out for capital expenditures, so it's worth making this distinction, although the lumpiness of capital expenditures makes consistent application of this number elusive. Incidentally, we don't regard price-to-book value (P/B) ratios as that helpful, because the book value of a company can be very elusive and arbitrary unless most of a company's a.s.sets are in cash or other easy-to-value forms.

Companies with high P/E, P/S, P/B, and P/CF ratios aren't necessarily bad investments, but you need to have good reasons to look beyond these figures if they suggest truly inadequate business results.

Strategic Intangibles.

When you look at any company, perhaps the bottom line question follows the Buffett wisdom: If you had $100 billion in cool cash to spend (and we'll a.s.sume the genius intellect to spend it right), could you recreate that company?

If the answer is "yes," it may still be a great company, but it may not be great enough to fend off compet.i.tion and keep its customers forever. If the answer is "no," the company truly has something unique to offer in the marketplace, difficult to duplicate at any cost. That distinctive competence, that sustainable compet.i.tive edgewhatever it is, a brand, a trade secret, a lock on distribution or supply channels, may be worth more than all the factories and high-rise office buildings and cash in the bank a company could ever have.

What we're talking about are the intangibles, the "soft" factors that make companies unique, that add up to more than the sum of their parts, the factors that ultimately drive future revenues. Intangibles not only define excellence, they define the future, while fundamentals mainly define the past. Seven key intangibles follow, although you'll think of more, and some industries may have some unique ones of their own, like intellectual property in the technology sector:

DOES THE COMPANY HAVE A MOAT?.

A business "moat" performs much the same role as the medieval castle equivalent.i.t protects the business from compet.i.tion. Whatever factors, some discussed below, create the moat, ultimately those are the factors that prevent you, with your $100 billion, from taking their business. Moats are usually a combination of brand, product technology, design, marketing and distribution channels, and customer loyalty all working together to protect a company. A moat doesn't just protect the existence of a company, it helps it command higher prices and earn higher profits.