As most investors are probably aware, headlines and mispricings often uncover short-term profit opportunities with stocks.
I actually talked about this last month, when I compared the fundamentals and insider position in Barnes & Noble (BKS) with Dell (DELL), then paired the analysis with two other stocks poised to pop. News broke the next day of Barnes & Noble Chairman Leonard Riggio's possible buyout plans of his company. The stock jumped 14%.
Also, CME Group's (CME) two-month profit of 18.6% followed another article recommending the stock.
But generational wealth is not made by continuously picking the right stock at exactly the right time. Truly successful investors find companies with great management that will make huge long-term returns.
So among the multitude of measures and screens (filtering stocks through specific variables), how does an investor pick stocks for their long-term holdings?
I struggled for what seemed like an eternity to get to the right answer.
But I've finally found four simple metrics that have rarely let me down in my search for quality companies. These metrics work well for any size company, but I like to focus on small and mid-sized companies for my long-term investments. The goal is to find an off-the-radar stock that could become the next Google (GOOG) or Microsoft (MSFT) before it explodes and other investors jump in.
And there's a way to do that...
Start with these metrics
1. Return on assets (ROA) is one of the best measures of how efficiently a firm uses its assets, and how well management turns capital into profits. It is the company's net income divided by total assets; it breaks down the firm's profit margin and asset turnover.
Many investors like to use return on equity as their preferred profit metric. (That's ROA times the company's debt leverage.) I prefer ROA because management can boost its return on equity above peers by taking on dangerously high levels of debt.
2. A firm's five-year average sales growth can say a lot about management's ability to consistently outperform peers consistently. Net income and many other financial accounts can be manipulated, but it is difficult to play tricks with sales. A company that can consistently beat peers in sales growth has a competitive advantage.
In all of these cases, compare apples to apples. For example, with sales growth across companies, compare firms of comparable size and sector. Double-digit sales growth in a mega-cap firm in a mature industry is a lot more impressive than the same growth at a small tech startup.
3. Operating margin measures management's operational efficiency. This may be my favorite metric. It is the company's earnings before interest, taxes, depreciation and amortization divided by revenue. Operating margin reduces the effect of accounting, financing and tax policies on profits.
You will probably see net margin more often quoted in the financial press. (That's the company's net income divided by revenue.) The net margin includes effects of discontinued operations, accounting changes and other extraordinary items management wants to throw in to manipulate earnings. I feel the operating margin is a more pure metric on how the company manages its expenses.
4. Finally, the insider and institutional ownership rate is my borderline decider. If the other metrics are good, but I cannot decide whether to invest, then I look at ownership. Insiders and institutional owners usually have access to information individual investors simply can't get. If they are optimistic about a company, then it could be because they have seen something I've probably missed. Be especially watchful for investments by activist shareholders. These are the institutional funds run by investors such as Carl Icahn and Mario Gabelli that buy positions in deep-value companies, then turn them around.
Notice I don't look at dividends for a long-term holding. Great managers are also great stewards of investor wealth. If they can reinvest income into the company and earn a higher rate of return than their cost of capital, then they should do so at the expense of dividends. I can create my own dividend by selling a portion of my position after it has increased, paying a lower tax rate on capital gains than income.
Looking under the radar
With these three metrics in mind, I found three companies that have caught my attention recently for their potential to deliver long-term returns through their consistent performance in these core metrics.
|1. Triumph Group|
| Triumph Group (TGI) designs, engineers and manufactures a portfolio of aerostructures, aircraft components and accessories for commercial and military aircraft. |
The company earns a return of 7.4% on its assets, well above the 3.5% average for peers in aerospace and defense. Its operating margin of 16.4% is more than double the 7.3% from most peers in the industry. The company has seen its sales grow by an annual average of 36% during the past five years, and insider/institutional ownership is extremely high at 96% of the shares outstanding.
While other defense contractors and suppliers may face hard times with lower government expenditures, the Triumph Group should continue to do well with its higher profitability and efficiency.
|2. Atwood Oceanics|
| Atwood Oceanics (ATW) is an international offshore drilling contractor with rigs in the Gulf of Mexico, South America, West Africa, Southeast Asia and Australia. |
The company earns a return of 9.9% on its assets, more than double the 4.3% average in the oil-well services sector. Its operating margin of 39% is way higher than almost all others in the industry, which average about 11%. The company has seen its sales grow by an annual average of 9.5% during the past five years, and insider/institutional ownership is 88% of the shares outstanding.
Outside of the United States, the next big thing in exploration is deep-water drilling. Atwood Oceanics, with its mobile offshore drilling units, has three ultra deep-water drill ships and the proprietary knowledge to make big progress in the sector.
|3. Gildan Activewear|
| Gildan Activewear (GIL) is a vertically-integrated global manufacturer of basic apparel, the items we need every day, such as socks and underwear. |
The company earns a return of 12.3% on its assets, almost double the peer average of 6.2%, and extremely high for a company in a mature industry such as apparel. Its operating margin of 11.5% is higher than most of the industry's companies, too, whose operating margin average is about 7.6%. The company has seen its sales grow by an annual average of 15% during the past five years, and insider/institutional ownership is 74% of the shares outstanding. Gildan Activewear beat expectations for sales and net income in the most recent quarter.
It also recently ramped up its purchase of raw materials, leading some analysts to believe that management predicts increased demand.
Risks to Consider: Not every company that beats peers in these four metrics will be a great stock for your long-term portfolio. Before investing, match measures with your opinion about the health of the overall market and the respective industry.
Action to Take --> Not every investment can be a two- or three-bagger inside of a few months. You also need stocks in your portfolio that are well-managed companies and consistently outperform their peers in the industry. This will help build a well-diversified portfolio with stocks that should deliver market-beating returns throughout your lifetime.