The inspiration for this post came from Richard Lazazzera, writer of the excellent e-commerce blog, “A Better Lemonade Stand” (another of my other passions). Be sure to check out Richard’s popular post “Reverse Engineering the Perfect Ecommerce Product” if you’re interested.
Reverse Engineering the Perfect Stock
I am going to tell you about the perfect stock that will make you millions of dollars. Few investors know about this stock even though it’s a multi-bagger in plain sight. Okay, on with it – what is it!? Here are a few clues…
The stock is a micro-cap, under $20M market cap, and has had three straight years of operating profits. The company is rapidly growing at over 25% per year, all of it generated organically. The company has high gross margins at 75% and a scalable business model, allowing operating earnings to grow at a 50% clip. The company’s industry is experiencing secular tailwinds and growth is expected to accelerate over the next few years.
Being a first mover, the company has no competitors in its niche and new entrants have failed to displace this company because of switching costs and the mission-critical nature of its product. The combination of pricing power and lack of capital requirements allow the company to achieve extraordinary returns on its invested capital, well over 100%. The company is debt-free and funds its growth entirely from operating cash flows.
Insiders collectively own 40% of the company and the CEO has a 25% stake. He bought in with his own money 5 years ago and has added to his stake through open market purchases. Management has maintained a clean share structure consisting of only 10 million shares outstanding and no warrants or preferred shares. The low float and small size of this company have kept its stock off the radar of institutions, which own less than 10%.
Okay perhaps by now you have figured out that I don’t have a ticker to share with you. And we all know there is no such thing as a “perfect stock.” That said, I believe there exists certain characteristics that form the DNA of any investor’s dream: a multi-bagger than you can hold on to for years. What follows is my list of 14 such qualities, organized by key fundamental, business model, and technical criteria (note I use stock/company interchangeably throughout). Enjoy!
I. Key Fundamental Criteria
Profits are the lifeblood of any company and cash flows generated by the business ultimately determine the value of your investment. A company that can fund itself internally avoids financing risks, which can cause massive losses through dilution or excess debt. While bio-techs prove positive cash flows are not necessary for success, working with profitable companies will simplify your valuation process and margin of safety assessment.
At a minimum, we will want to see two solidly profitable quarters and preferably a 3-year track record of profits (or more!).
2. Rapidly Growing
Assuming a company is generating returns on capital above the costs of that capital, growth is enormously beneficial to the company and its shareholders. New products, customers, and business lines typically bring more profits and drive the company’s intrinsic value.
Ideally, all of this growth should be organic. Too often, acquisitions don’t deliver on their promised synergies and yield much of their value to the seller through premiums paid. We will want rapid organic revenue growth, a minimum of 25% y/y.
3. Attractive Valuation
The key to investing is not finding the best companies, but rather the largest discrepancies between price and intrinsic value. Buying at a low valuation provides downside protection in the event your thesis does not play out, while allowing for huge upside if things go well. Valuation is more art than science, and finding the most useful metrics to employ can be tricky.
My valuations always begin with an adjusted EV/EBIT multiple, which incorporates the company’s balance sheet and strips out non-operating items to better present true earnings power. We will want this multiple below 10 and ideally below 7 – the lower, the better.
4. No Debt / Financing Requirement
Debt can juice a company’s returns but often leaves the business vulnerable to the unexpected: a major customer loss, a regulatory change, or a patent infringement suit. This situation is made worse when the market knows an equity raise is coming, effectively holding the company hostage to its share price. Investing carries enough risk as it is – crossing off dilution/bankruptcy risk is key to putting the odds in your favor.
Example: A $10MM market cap company has $6M in debt, no cash, earns $2M a year in EBIT, and trades at 8X EV/EBIT. If the company suffers a major contract loss which cuts EBIT in half, you would face an 80% loss on your investment assuming the company maintains its valuation multiple(1M X 8 = 8-6 = 2M). High leverage magnifies negative events in a big way.
We will want our company to have no debt and a few million dollars in the bank for growth investment. The company should have no need for future debt/equity raises and fund itself entirely through internal cash flows.
II. Business Model Criteria
5. Durable Competitive Advantage
Durable competitive advantages, or economic moats as Warren Buffet calls them, are derived from only a handful of sources: brand power, switching costs, patent/government protection, and network effects. Economic theory holds that in absence of one of these forces, competitive pressure will reduce all company’s Return on Invested Capital (ROIC) to the cost of capital.
Sources of economic moats are not all created equal. Government protection often proves unsustainable and brand power can be just as easily eroded in some cases. We will want our company to benefit from switching costs, network effects, or both. Banks, software providers, and business service companies are all beneficiaries of switching costs. Social media and auction platforms are prime sources of network effects.
6. High Returns on Capital / Low Capital Requirements
The less capital investment a company requires to keep its competitive position, the more profits that are left over to invest in growth or be returned to shareholders. By nature, some companies require little capital while others require seemingly endless amounts to stay afloat. This intrinsic quality, along with competitive positioning determines the ROIC our company can achieve. ROIC is a key value driver – the higher the ROIC, the more shareholders stand to benefit from growth.
Example: Capital-light/high-ROIC businesses include software, database, and franchising companies. Capital-intensive/low-ROIC investments to be avoided include railroad companies, automotive manufacturers, and above all, airlines. By requiring our company to have a ROIC above 50%, we will be big beneficiaries from any growth the company generates.
7. High Gross Margins
Gross Margin (GM) refers to how much profit is left after the direct costs of products/services are covered. The higher the gross margin, the more profits will accelerate with sales growth.
Example: If Business A has 75% GMs and Business B has 25% GMs, Business A will experience three times the impact on profits from each dollar of new business as compared to Business B. High gross margin companies include patent licensors, medical device manufacturers, and pharmaceutical companies. Examples of low gross margin companies are automotive suppliers, construction contractors, and retailers.
Gross margins will vary widely based on industry but in general, the higher the better. We will want our company to have gross margins of at least 50%.
8. Scalable Business Model
Scalability refers to a company’s ability to leverage its infrastructure as it grows. A good measure of this is the Degree of Operating Leverage (DOL), or the percent change in EBIT divided by the percent change in revenues.
Example: Once a Software-as-a-Service (SaaS) company invests in the infrastructure to create and sell its software, each incremental subscription can be delivered at virtually no additional cost. Compare this model to a restaurant, which must pay rent, labor, and food costs with every location opened. Software and database companies are often scalable, while restaurant operators and manufacturers tend not to be.
Ideally, we will want our company’s operating expenses to grow at half the rate of revenues or less (DOL >= 2).
9. Non-cyclical, Recurring Revenues
Recurring revenues afford a business the advantages of predictable cash flows to base investment decisions on and high lifetime customer values. Recurring revenues also aid investors in projecting future cash flows and performing valuations. A stable, non-cyclical business offers the similar advantage of predictable cash flows, while offering safety in case of a sharp economic downturn.
Example: Any business with a subscription model, such as SaaS or security monitoring, is likely to have recurring revenues. Food, tobacco, and alcoholic beverage companies are all classic examples of recession-resistant businesses.
We will want a business with over 50% of their revenues recurring and a low sensitivity to general economic conditions.
III. Technical Criteria
Much like large companies forge their own anchors as they grow, small companies have the law of small numbers on their side. Small size often offers a long runway for growth and magnifies each positive development.
Example: Think of a SaaS company doing $10M per year annually that announces a $2M contract. This business becomes 20% more valuable over night, and perhaps far more given the operating leverage inherent in software.
We will want to stick to companies below a $300M market cap, and ideally less than $50M.
11. Low Float / Clean Share Structure
Low float (freely tradeable shares) results from a low share count, high inside ownership, or a combination of the two. From a technical standpoint, a low float can lead to massive price increases as investors rush to bid on a limited supply of shares. On a more fundamental level, the float is a reflection of how management has financed the business in the past and their relative ownership of the company.
We will want no more than 50M shares outstanding and preferably less than 30M. The float should be significantly lower due to insider ownership (discussed below). We will also want to see a clean share structure, with no warrants or exotic convertible instruments.
12. High Insider Ownership
We want a management team that behaves like owners and this is not possible unless they are owners. For the micro-caps we are interested in, we will want to see insiders collectively owning at least 30% of the company, with the CEO himself owning at least 15%. It is also important to assess how management got their stakes – did they buy in with their own money or was it given to them through options and share grants?
Management adding to their stakes through open market purchases is often a big plus. This demonstrates insiders believe in the company’s future and you should too.
13. Low Institutional Ownership
For a variety of reasons, many institutions cannot invest in the micro-caps we are interested in. Some have restrictions against stocks under $5 or companies that trade on the Over-the-Counter Exchange (OTC). With all the desirable qualities discussed thus far, institutions will be drooling over our company waiting for the company’s size/liquidity to reach their buying criteria. When this happens, look out! Triple digit gains are quite likely as institutions pile into a “must own” stock.
To leave this big catalyst open, we will want to see institutional ownership under 10%.
14. Secular Industry Tailwinds
Never forget to look beyond the fundamental and technical factors to understand the underlying trends in the company’s industry. Beyond a company’s own efforts, secular industry tailwinds are often necessary to sustain our 25+% revenue growth target. Industry tailwinds also have the bonus of attracting investor attention, which can lead to big gains as our company is viewed as a unique play in a hot sector.
Example: Organic foods, mobile applications, and network security software are all industries undergoing secular growth phases.
So there you have it, all the ingredients that go into my “perfect stock.” In practice, few stocks will meet all these criteria and employing a 1-5 scale rating for each is a method I like to use. You may have to analyze 1000 companies to find one that scores well on all the criteria, but trust me, it will be well worth your time!
If you are interested in learning more, check out theses posts (1, 2) by investor Mike King on his “secret recipe” for stock picking. His near-perfect stock was Biosyent (RX.V, BIOYF) and it is been an absolute monster, up some 400% since his post.
In a follow-up post, I will share with you my biggest winner of all time and how well it scored across these criteria at the time of my analysis. Until then, on to searching for the perfect stock…
Disclosure: No position in any stocks mentioned