The 100 Best Stocks You Can Buy 2012 Part 4

Whether a company has a "narrow" moat, a "wide" moat, or none at all is a subjective a.s.sessment for you to make. However, you can get some help from Morningstar (www.morningstar.com) whose stock ratings include an a.s.sessment of the moat.

Coca-Cola has a moat because of the sheer impossibility of surpa.s.sing its brand and brand recognition worldwide. CarMax has a moat because it is farther along in putting retail-style dealerships on the ground and applying management information technologies to its business than anyone else is; it would take years for a compet.i.tor to catch up. The "Moat Stars" list presented earlier identifies the top ten stocks with a solid and sustainable compet.i.tive advantage.

DOES THE COMPANY HAVE AN EXCELLENT BRAND?.

It's hard to say enough about brand, especially in today's fast-moving, highly packaged, highly national and international marketplace. A strong brand means consistency and a promise to consumers, and consumers sold on a brand will prefer it over any other, almost regardless of price. People still buy Tide; Starbucks is still synonymous with a high quality and ambience. Good brands command higher prices, and foster loyalty and ident.i.ty and even customer "love." Again, using the Starbucks example, websites appeared soliciting customer appeals to not close stores during the recent store-closing initiative; when has anyone (other than a worker) offered so much resistance to closing a U.S. auto plant? Once a company has created a dominant brand (or brands, in the case of P&G) in the marketplace, aside from some major faux pas, they will endure and continue to create value for shareholders for years to come; a good brand is one of the most valuable (yet hard to value) long-term a.s.sets around.

Ask yourself if a company has a sought-after brand, a brand customers would pay extra to buy or align with, a brand that would be difficult to duplicate at any cost. Would customers rather fight than switch? Think about Starbucks, Coca-Cola, Heinz, Nike, or the brands within a house, like Frito-Lay (Pepsi) or Tide (P&G).

IS THE COMPANY A MARKET LEADER?.

Market leadership usuallybut not alwaysgoes hand in hand with brand. The trick is to decide whether a company really leads in its industry. Oftenbut not alwaysthat's a factor of size. The market leader usually has the highest market share, and the important point is that it calls the shots with regards to price, technology, marketing message, and so forthother companies must play catch up and often discount their prices to keep up. Apple is a market leader in digital music, Intel is the market leader in microprocessors, and, despite a few setbacks, Toyota is emerging as the market leader in automobiles.

Excellent companies tend to be market leaders, and market leaders tend to be excellent companies. But this relationship doesn't always hold truesometimes the nimble but smaller compet.i.tor is the excellent companyand will likely a.s.sume market leadership eventually. Examples like CarMax, Nucor, Perrigo, and Southwest Airlines can be found on our list.

DOES THE COMPANY HAVE CHANNEL EXCELLENCE?.

"Channels" in business parlance means a chain of players to sell and distribute a company's products. It might be stores, it might be other industrial companies, it might be direct to the consumer. If a company is considered a top supplier in a particular channel, or a company has especially good relations with its channel, that's a plus.

Excellent companies develop solid channel relationships and become the preferred supplier in those channels. Companies like Dentsply, Patterson, Fair Isaac, McCormick, Nike, Pepsi, Procter & Gamble, and Sysco could all have excellent relationships with their channels through which they sell their product.

DOES THE COMPANY HAVE SUPPLY CHAIN EXCELLENCE?.

Like distribution channels, excellent companies develop excellent and low-cost supply channels. They are seldom caught off guard by supply shortages and tend to get favorable and stable prices for whatever they buy. This is often not an easy a.s.sessment unless you know something about a particular industry. Hewlett-Packard and Nike are examples of companies that have done a good job managing their supply chains.

DOES THE COMPANY HAVE EXCELLENT MANAGEMENT?.

Well, it's not hard to grasp what happens if a company doesn't have good management; performance fails and few inside or outside the company respect the company. It's not easy for an investor to determine if a management team does a good job or acts in shareholder interests. Clues can include candor and honesty and the ability of company management to speak in accessible, easily understood terms about the company and company performance (it's worth listening to conference calls as a resource). A management team that admits errors and eschews other forms of arrogance and ent.i.tlement (i.e., luxury perks, office suites, aircraft) is probably tilting his or her interests toward shareholders, as is the management team that can cough up some return to shareholders once in a while in the form of a dividend.

This may be the most subjective and elusive a.s.sessment of all, as few investors work with these folks on a daily basis. Still, over time, you can garner a strong hunch about whether a management team is effective and on your side.

ARE THERE SIGNS OF INNOVATION EXCELLENCE?.

This question seems pretty obvious, but it's not just about the products that a company sells. True, if the company is leading the industry in innovation, that's usually a good thing, for "first to market" definitely offers business advantages.

The less obvious part of this question is whether the company makes the best use of technology to make operations and customer interfaces as efficient and effective as possible. Southwest Airlines may have missed our list in the past because of the difficulty of achieving excellence in an industry where players can't control prices or costs. But they do make our list today, not only because of brand and management excellence, but also innovation excellence. Why? Simply because, after all of these years, amazingly, they still have the best, simplest, easiest-to-use flight booking and check-in in the industry. Sometimes these sorts of innovations mean a lot more than bringing new, fancy products and bells and whistles to the market. And one can also look to Apple, Google, and CarMax on our list for more obvious examples of companies that have deployed technology and innovative customer interfaces to achieve sustainable compet.i.tive advantage.

IT PAYS TO FIND A SMART FRIEND IN THE BUSINESS.

Most publicly traded companies are required to report their fundamentals on a quarterly and an annual basis through income statements, balance sheets, and statements of cash flows. That's good, because we as investors can easily see how the company is performing; we don't need to get on the phone with the CFO to check the progress of our investment.

But what about the intangibles? Companies are required to report exactly nothing of their brand strength, market position, new product pipeline, or management style. Sure, you may read a lot in an annual report, but it's as much a spin, a marketing message to investors, as it is the real "scoop" about what is or what's going to be.

So how do you fill this information gap? One way is to keep up with the trade press and trade publications of the industry you invest in. Like technology stocks? Read technology magazines and websites, and the technology sections of the Wall Street Journal and the New York Times. But if you really want the inside scoop, make friends with people who work in the industry. They are (or should be) experts in their business. They know the products and the compet.i.tion. It's not so much that they'll divulge trade secrets about the company they work for; that isn't the point. Instead, they'll help you see where the puck is going for the industry, their company, and other players in their industry. The thousand words you get from a friend in the business can be worth far more than the picture in the annual report.

Choosing the 100 Best.

So with all of this in mind, just how was this year's 100 Best Stocks list actually chosen? It's probably about time, after pages and pages, to get to that.

The answer is a little more subtle than you might think. If we could give you a precise formula, you wouldn't need this book. You'd be able to do it yourself. In fact, every investor would be able to do it on his or her own. Our book would simply be the result of yet another stock screener. And every investor would invest in the same stocks. Is that a feasible or practical solution? Hardly. Everyone would scramble to buy the same 100 Best Stocks. The prices would be sky high, and the price of other stocks would melt to nothing.

SIGNS OF VALUE.

Following are a few signs of value to look for in any company. Not an exhaustive list by any means, but a good place to start:.

Gaining market share.

Can control price.

Loyal customers.

Growing margins.

Producing, not consuming, capital (free cash flow).

Steady or increasing ROE.

Management forthcoming, honest, understandable.

SIGNS OF UNVALUE.

... and signs of trouble, or "unvalue": Declining margins.

No brand or who-cares brand.

Commodity producer, must compete on price.

Losing market dominance or market share.

Can't control costs.

Must acquire other companies to grow.

Management in hiding, off message, making excuses, or difficult to understand.

Fortunately or unfortunately, however you want to look at it, it isn't that simple. There are too many fundamentals, too many intangibles, and too many unknown and unknowable weighting factors to combine the fundamentals and intangibles thatwellit just wouldn't work. No screener could recreate the subtle judgment that gets applied to the cold, hard facts. It's that judgment, the interpretation of the facts and intangibles, that makes it worth spending money on a book like this.

While we didn't apply a specific formula or screener to the universe of stocks, we did take a few measurable factors into account to narrow the list from thousands to a few hundred issues. Those factors came from several sources, but at this point, we must tip our cap to Value Line and the research and database work they do as part of the Value Line Investment Survey. If you aren't familiar with Value Line, it's worth a look for any savvy individual investor, either online at www.valueline.com or, in many cases, at your local library. It is an excellent resource.

Anyway, here are some of the measured factors we looked into, most of which go beyond individual facts or items and instead are measures of strength or performance compiled from a number of factors. In this way, we gain some leverage for not having to deal with lots of little bits of individual data. Here are six metrics we use as a starting point to select and sort stocks for further review: * S&P Rating is a broad corporate credit rating reflecting the ability to cover indebtedness, in turn reflecting business levels, business trends, cash flow, and sustained performance. It's a bit like the credit score you might use or might have used to determine your own personal credit risk.

* Value Line Financial Strength Rating is used much like the S&P rating except that it goes further into overall balance sheet and cash flow strength. It should be noted that several companies with "B" ratings were selected; these are typically newer companies that will grow into "A" companies or that may have been hit harder by the recession than others.

* Value Line Earnings Predictability is what it sounds like, a calculated tendency of companies to deliver consistent and predictable earnings without surprises.

* Value Line Growth Persistence is again what it sounds likethe company's ability to consistently grow even in weaker economic times.

* Value Line Price Stability reflects the stability and relative safety of a company. Again, we did not reject a company out of hand due to volatility; rather, if stability was low, we tried to make a case that the business, business model, and intangibles were worth the risk.

* Dividends and Yield. Companies that pay something are held in higher regard; however, again, it is not by any means an absolute criterion.

With these facts and figures in mind, the evaluation proceeded with a close eye on the "signs of value" and intangibles mentioned above. Some consideration was also given to diversification; we did not want to over-weight any sector or industry, but rather to give you a healthy a.s.sortment of stocks to pick from across a variety of industries.

With these thoughts in mind, you can make more sense of the companies we picked. And of course, full disclosure and full disclaimerwe didn't do all the a.n.a.lysis. We couldn't have. It wouldn't have made any sense anyway, for things would have changed from the time we did it, and it might not match your preferences anyway. So it is of utmost importance for you to take our selections and a.n.a.lysis and make them yoursthat is, do the due diligence to further qualify these picks as congruent with your investment needs.

The Surgeon General would label this book as "hazardous to your wealth" if you didn't.

Strategic Investing.

Although this book is designed to help you pick the best stocks to buy, investing by nature goes well beyond simply buying stocks, just like owning an automobile goes far beyond buying it. Just as clearly, this book isn't about investing strategy, or about the personal financial strategies necessary to ensure retirement or a prosperous future. That said, we think a few words are in order.

We find that a lot of investors lose the forest in the trees, spending all of their energy trying to find individual stocks or funds without putting enough consideration into their overall investing framework. If they look at the big picture at all, they look at the formulaic covenants of a.s.set allocation, a favorite subject of the financial planning and advisory community, as though the difference between 50 percent equities and 60 percent equities makes all the different in the world. Sure, it might in the world of pension funds and other inst.i.tutional investments, where a 10 percent adjustment could move millions into or out of a particular a.s.set cla.s.s and more or less toward safety, but what about a $100,000 portfolio? Does $10,000 more or less in stocks, bonds, or cash make that much difference?

Perhaps not. And of course there's more to that storydoesn't it matter more which equities you invest in than just the fact that you're 60 percent in equities? So while a.s.set allocation models make for nice pie charts, we prefer to approach big-picture portfolio constructs differently.

Start with a Portfolio in Mind.

First, we'll make an a.s.sumption. That a.s.sumption is simply this: You are not a professional investor. You have other things to do with your time, and time is of the essence. You cannot spend forty, fifty, or sixty hours a week glued to a computer screen a.n.a.lyzing your investments.

To that a.s.sumption, we'll add another: that, as an individual investor, you're looking to beat the market. Not by a ton20 percent sustained returns simply aren't possible without taking outlandish risks. But perhaps if the market is up 4 percent in a year, you'd like to achieve, 5, 6, perhaps 7 percent without taking excessive risks. Or if the market is down 20 percent, perhaps you cut your losses at 5 or 10 percent. You're looking to do somewhat better than the market.

Because of time constraints, and owing to your objective to do slightly better than average, we suggest taking a tiered approach to your portfolio. The tiers aren't based on the type of a.s.sets; they're based on the amount of activity and attention you want to pay to different parts of your portfolio. It's a strategic portfolio approach you would probably take if you were managing a small businessput most of your focus on the products and customers who might bring the greatest new return to your business; let the rest of your slow steady customer base function as it has for the long term.

We suggest breaking up your portfolio into three tiers or segments. This can be done by setting up specific accounts; or less formally by simply applying the model as a thought process.

We can't go much further without defining the three segments:.