Apart from those investors committed to indexing strategies, everybody is on the hunt for market-beating stocks. After all, if you do not expect a stock to beat the market, why take the risk that goes with individual stock selection? While investors should always be suspicious of any advice claiming to offer easy strategies to spot market-beating stocks, long-term high performers do seem to share certain traits. (For related reading, also take a look at How To Make A Winning Long-Term Stock Pick.)
A Short-Term Warning
Before talking about how to spot market-beating stocks, a word of caution is in order. The motivating principle of this column is to find stocks that beat the market for the long term. In the short term (18 months or less), almost anything can "work" and outperformance is based largely on investor enthusiasm and stock market momentum.
Unfortunately, that system does not hold up so well over time - last year's winners tend to be next year's losers as the enthusiasm fades, momentum investors move on and high valuations are no longer ignored by the market. Consider the words of Warren Buffett who has said (perhaps quoting his mentor Ben Graham) that, "in the short-run the market is a voting machine; in the long run, it's a weighing machine." With that in mind, here are the hallmarks of a market-beating stock.
1. Excess Economic Profits
Ultimately, the companies that win over the long term are the companies that follow a deceptively simple formula. These companies earn economic profits in excess of their cost of capital. To some extent, though, this is a tautology that is not all that helpful. After all, companies do not report their economic profits (they report accounting profits, as determined by GAAP rules) and no two analysts will ever agree completely on the proper calculation of the cost of capital.
2. Strong Returns on Invested Capital (ROIC)
Return on invested capital is a pretty handy substitute for separating out those companies that are earning the sort of returns that lead to long-term success. Return on capital divides some measure of the company's profitability (net income, EBITDA, NOPAT, et al) by the company's capital base (debt and equity).
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