Investment Consult

Nine traits of winning companies

It's no accident that certain stocks perform consistently well. Here's what they have in common.

Lewis J. Altfest, PhD, CFA, CFP

In this recessionary environment, when every stock seems to be languishing, it's not easy to earn blockbuster returns. Yet winning companies abound, in all sizes and styles. To find them, you just need to know what traits to look for.

You may already realize the importance of a low price-earnings ratio; when it indicates the stock is cheap (as it usually does), the greater your potential return. But here are nine other important qualities:

1. Active buying by management. I consider this the best signal to invest. When managers buy shares, it means they think the stock is cheap. To see whether the company is buying back shares or its officers are investing their own cash, visit Morningstar's Web site (www.morningstar.com), enter the ticker symbol, then click on "Ownership." Or go to Yahoo! Finance (finance.yahoo.com), enter the ticker symbol, and click on "Insider" in the "Basic" stock report.

2. Earnings surprises. A stock performs well when the company's earnings exceed Wall Street's expectations. I've found it's better for a company to increase earnings, say, 10 percent a year when analysts anticipate 7 than to grow 20 percent when they expect 25.

Some companies, including Disney and Microsoft, have a knack for controlling expectations and then delivering pleasant surprises. That's easiest to do when investors feel negative about the industry or market sector.

3. Dominant market share. Successful companies usually enjoy a sizable share of the market, which can protect them during down cycles. For example, in the fast-food world, McDonald's has the upper hand over Wendy's International. Unless it has an innovative product and is clearly gaining market share, I wouldn't invest in a second- or third-tier player that's not trading at a discount to its true worth.

4. Good PR. Have you noticed that some companies, such as General Electric and Intel, seem to have a knack for getting positive news into the media? It shouldn't surprise you that money tends to flow toward those companies. They're perceived as safe and progressive.

The best of these media-friendly firms also cater to, and are honest with, investment analysts. Excellent two-way communication—with the Street as well as the public—can create a positive image that boosts a stock's price.

5. Handle on debt. In good times, many investors ignore the amount of debt on a company's balance sheet. Certainly that's a mistake, as the dot-com debacle taught us. Moreover, looking closely at debt as well as earnings per share can help you spot pearls, especially in beaten-down industries.

Take Southwest Airlines. The company was able to weather the turbulence created by the Sept. 11 attack because it has averaged more than 15 percent annual earnings growth over the past 17 years while carrying minimal debt. (I like to see a company keep its long-term debt below 40 percent of its market capitalization.) Southwest's finances remain in good shape despite the downturn in passenger traffic, and I consider it an excellent investment.

6. High return on equity. This characterizes any strong business. In brief, the higher a company's ROE, the more effectively it uses its capital. I'd rather own a company that grows 12 percent a year and has a high return on equity than one that rises 15 percent but has a low ROE.

Using a trusted source such as Morningstar, look for companies that consistently return 20 percent or more on equity and keep long-term debt low. Many companies in the pharmaceutical industry—including Johnson & Johnson, Merck, and Pfizer—currently meet these criteria.

7. Smart management team. The top-performing companies have visionary leaders as well as management programs that attract and reward sharp people. You can tell how savvy these companies are by the way they react to adversity. Again, Southwest Airlines proves a good example: It opted not to eliminate flights or employees after Sept. 11. That boosted morale and very likely allowed the airline to win some passengers from its rivals.

On the other hand, when earnings flatten or decline, a smart CEO won't hesitate to reduce staff and reorganize the company—before shareholders apply pressure. These moves can establish the groundwork for a strong turnaround.

8. Consistent growth. Although this should go without saying, many investors ignore consistency. They're dazzled by a single year of superior growth and assume the company will hit the mark again and again. However, strong short-term earnings often result from layoffs, divestitures, or the like. Look instead for companies whose sales and earnings have grown in each of the past five calendar years, as Wal-Mart's and American Express' have. Stocks like these have the potential to shine during tough times and, ultimately, to provide solid long-term returns.

9. Leader in a popular industry. Stocks of companies in certain industries, such as biotech and entertainment, tend to be valued higher than the raw numbers suggest they should be. Stodgier industries—including home builders and utilities—always seem to get shortchanged. If you find a fast- or steadily growing company in a popular industry and its stock is selling at a fair price, you have a potential winner.

The author, a fee-only financial planner, is president of L.J. Altfest & Co.( www.altfest.com ), a financial and investment advisory firm in New York City. This column appears every other issue. If you have a comment, or a topic you'd like to see covered here, please submit it to Investment Consult, Medical Economics magazine, 5 Paragon Drive, Montvale, NJ 07645-1742. You may also send a fax to 201-722-2688 or e-mail to meinvestment@medec.com.

Lewis Altfest. Investment Consult: Nine traits of winning companies. Medical Economics 2002;6:25.