7 Ingredients of Market-Beating Stocks

The Investopedia Advisor's 7 Ingredients to Market-Beating Stocks:

Ingredient #1:
Don’t “Pick Stocks” - Invest in Companies(At The Right Price)
• It’s all about the fundamentals.
• Think about investments from the perspective of an owner and stop renting stocks.
• Look for companies with wide economic moats.
• Don’t forget about price!

Ingredient #2:
Focus on the Important Factors
• Once you filter out the noise in the stock market, you can objectively analyze stocks.
• Focus on factors such as profit margins, cash flow and general financial health.

Ingredient #3:
Avoid Big Mistakes (and Losses)
• After analyzing your stocks for potential red flags, be sure there is still a built-in margin of safety.

Ingredient #4:
Don't Lost Site of the Big Picture
• After analyzing your stocks for potential red flags, be sure there is still a built-in margin of safety.

Ingredient #5:
Know Thyself
• After analyzing your stocks for potential red flags, be sure there is still a built-in margin of safety.

Ingredient #6:
Avoid Conflicts of Interest
• Getting investment ideas from an unbiased source is critical (just ask those who invested in the tech stocks to which analysts had given “buy” ratings while privately calling them “junk").

Ingredient #7:
Remain Confidently Contrarian
• When everyone is talking about something, it’s probably too late.

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Ingredient #1
Don’t “Pick Stocks” - Invest in Companies (At The Right Price)

Warren Buffett, arguably the world’s greatest investor, has often preached: “buy companies, don’t rent stocks”. At the Investopedia Advisor, we couldn’t agree more. Accounting gimmicks or other corporate smoke and mirrors don’t create wealth.

While the stock market can get irrational for a short period of time, it’s those companies with real products and real profits that create shareholder wealth in the long run. It’s these companies that we’re looking to find for our members.

It really isn’t that complicated. There is a lot of common sense involved. Investing in equities is about finding well-run companies with strong fundamentals.

When you buy a company’s stock you have to think just like you are becoming an owner of the business - because that’s what you’re doing!

Far too many investors treat their holdings like rented goods. They ignore the long-term and treat the stock market like their personal casino.

We’re not saying that you can’t make money in the short-term – some people do make a good living trading, but at the Advisor it’s not our style.

Before making a recommendation, we pretend that a company is a private entity (that is, not trading on a stock exchange). When a company is private you can’t easily sell your shares to the next investor who comes along. Instead, you have to make money the old-fashioned way – with profits.

Yup, it’s all about selling something for more than it costs you to produce it.

In the long run, it is profits that drive share price.

So what are some of the things we’re looking for in these so-called “good companies”?

The Economic Moat
One of the most important characteristics great companies have is a wide economic moat. Basically, an economic moat is a defense system that protects a company’s current (and future) earnings from competitive pressures.

Economic moats come in many forms. They can be anything that gives a company an advantage over the others in the industry. This includes economies of scale and cost advantages, high switching costs, great management, a strong brand name, superior technology, etc.

Whatever it is, an economic moat prevents competitors from stealing market share and gives the companies in which we invest the opportunity to continue to make money – in other words, an economic moat provides sustained profitability!

We believe economic moats are at the heart of a company’s long-term success. Take, for example, Wal-Mart’s low-cost advantages obtained through just-in-time inventory practices and aggressive cost controls. These factors have fueled the company’s exceptional growth over the past two decades and continue to ward off the advances of competitors.

Don’t Forget About Price
While we look for strong economic moats in our holdings (especially in our Core Holdings Portfolio), even the company with the widest and most sustainable economic moat may not be a good addition to your portfolio; it may be overpriced!

Stepping back to December of 2003, it wouldn’t have been unreasonable to conclude that Intel Corp. enjoyed (and still enjoys) a wide economic moat. Yet, in retrospect, it is probably fair to say that the stock was overpriced, since it fell from a high of nearly $30/share to under $20 by September of 2004. See the chart below:

We have nothing against Intel. It’s a good company that in many ways has revolutionized the world with its processors. However, the problem with investing in companies with strong economic moats that are fairly priced is that doing so requires three rare commodities amongst investors: time, effort and independence.

It's not easy to tirelessly conduct research, do your homework, drown out noise from Wall Street’s analyst horde and remain diligent while your investments earn money for you, all the while remaining completely unbiased and independent.

Simply put, when it comes to most of the major sources individuals use to acquire stock ideas, this combination rarely comes together.

This is exactly why so many individuals flock to the next “guaranteed stock-picking machine” or the next “can’t-miss strategy that takes only minutes a day” – they simply do not have the time and patience it takes to research companies. The fact is, THERE IS NO MAGIC BULLET FOR PICKING STOCKS.

That said, a person's ability to pick stocks can be aided greatly by the three characteristics mentioned: time, effort and independence. Wealth is not built overnight, and it most certainly takes the right mixture of patience, committed effort and a guiding hand to keep you on track.

Take, for example, a company that we added to our Core Holdings Portfolio in July 2005. The company is not a high flier; in fact, its business is quite boring: they store stuff. They store paper; they store documents; they store digital records. But they have almost the entire industry sewn up and hold such a dominant position within the industry that competitors have hardly even attempted to peck away at market share.

Put simply, it’s a great company with a wide economic moat that was trading at a favorable price.

We're adamant about the patience it takes to find these types of companies with our analyst team. The team is truly committed to putting in the time and effort needed to identify these superior companies.

Ingredient #2
Focus on the Important Factors, Filter the Noise

'Important' - this is a word that means different things to different people. Ever witness a Formula One race in action? What tends to make the highlight reels on the evening news? Spectacular crashes, incredible passes, the obligatory victory burnout and the winning driver quenching his thirst with whatever beverage sponsors him ...

But what actually separates the leaders from the laggards?

Superior engineering, old fashioned wrench-turning, efficient pit crews and consistent driving are key factors. Obviously, the people whose careers are riding with the car have a much different definition of 'important' than the people looking down from the media booth, the fans sitting in the grandstands or the late-night sports highlights junkie.

In the investment world, the same dichotomy exists. Financial news is produced by writers who seek out the most exciting, scintillating and engaging stories possible; their success is measured by the size of their audience base and the reactions garnered.

While their efforts make for entertaining coverage, you as individual investors have different needs when it comes to analyzing your stocks.

Most of what you read and see in the daily news is noise. It’s not necessarily false, but it may be immaterial. If you are going to own part of a company, you need to filter out the noise and focus on the important economic factors affecting your company and its industry.

At the Investopedia Advisor, we prefer to focus on the business fundamentals of the companies we follow and leave the media noise to others.

Once you’ve filtered out the noise, you’ll be able to look at a company’s fundamentals objectively. But what is it you should be looking for?

Margins, Margins, Margins

A great place to start is looking at your company’s profit margins - including their sustainability and future growth potential. At the end of the day, there are few factors that are more important, from an investor’s point of view, than healthy and sustainable margins for their holdings.

If your holdings have sustainable or even improving margins, you have a much better chance of succeeding in the long run.

For example, let's look at the software industry's perennial 800-pound gorilla, Microsoft. Microsoft's stock has not enjoyed the same dramatic increases over the past few years that were seen during its legendary past, yet few investors would worry that a significant drop in this company's share price lies ahead.

This is partly due to the fact that Microsoft’s operating margins remain very healthy. When you look at companies who lack stability in their operations, things become much less certain.

Below we compare Microsoft to Sun Microsystems, which at the time of writing struggled with a bleak operating margin of -4.2%." or whatever you think is best.


It is clear that based on profit margins, Microsoft is a much healthier company than Sun Microsystems.

Of course, margins aren’t the only thing we consider.

With all the companies we look at, we also carefully examine cash flow. The level of scrutiny may vary depending on where a company is in its lifecycle, but trend is very important.

In our Core Holdings Portfolio (one of the three model portfolios we offer our members), we steer clear of a lack of strong and consistent cash flow. With the selections in the Undiscovered Growth and Swing for the Fences portfolios, we focus more on the current trend of cash flow (i.e. Is it going in the right direction?).

There are other critical business metrics to focus on before going ahead and investing dollars into a company.

However, by focusing on only the important factors - such as profit margins and cash flow - you can weed out the hype and media spin and successfully locate solid companies instead of getting sidetracked with media darlings, which will not seem nearly as entertaining after they take a bite out of your portfolio.

Ingredient #3
Avoid Big Mistakes (and Losses)

How often have you looked at your performance over a period of time and thought to yourself : “I would have done outstanding if it wasn’t for this one dud of a company.”

Indeed, when it comes to this ingredient of the Investopedia Advisor’s success plan, our old friend Warren Buffett again has the right words when he says: “An investor needs to do very few things right as long as he or she avoids big mistakes.”

So how do you avoid taking catastrophic detours on the road to financial success?

We think there are a few tools that individual investors can use to mitigate the risk. Our first line of defense is to establish and maintain a healthy margin of safety.

No investor has ever been correct 100% of the time, and it is incredibly naïve for anyone to believe that it is possible to make investment after investment without ever having a few of them turn out differently than expected.

A sufficient margin of safety can be difficult to quantify, but our philosophy is easily understood with an example of everyday risk management.

Consider Joe the engineer. Joe has recently been contracted to engineer a new bridge. He is given the task of erecting a bridge able to withstand 75 tonnes of weight. Do you suppose Joe is going to engineer the bridge in such a way that it will hold only 75 tonnes and not a pebble more?

Of course not.

Joe is going to engineer the bridge to hold much more than that, building in a margin of safety for any miscalculation.

Joe will probably engineer the bridge so that it will be able to withstand the weight of 100 tonnes, creating a 25-tonne margin of safety.

Now, consider the situation from an investment standpoint. Would you invest in a company trading at $75 when you estimate its worth to be only $76? This leaves you very little margin for error - any slight miscalculation and you just paid too much for the stock.

More likely, especially if you adhere to the Investopedia Advisor philosophy, you are going to seek a company whose value you have calculate to be $100 per share that is only trading at $75. This allows a margin of safety. Even if your calculations are slightly off and the company is only worth $85 per share, you still purchased an asset for less than its worth!

Red Flags – The Death of Any Investment!
Before adding a stock to our model portfolios, we test for numerous risk factors, which we call 'red flags'. Red flags such as a poor management history, shaky corporate governance, questionable accounting procedures, a convoluted business plan, or an unreasonable option-based compensation plan are all key factors we attempt to expose when analyzing a company.

For example, we would never include companies with poor corporate governance in our line of portfolios, since even the best business models can be ruined by poor leadership in the upper ranks.

When it comes to accounting, if a company’s financial statements leave us more confused about their operations, we know to keep our distance. While not every company with obscure financials is necessarily the next Enron, we need to avoid those that have the chance of becoming one.

We also restrict ourselves to making investments with companies that have a clear business plan. In our opinion, far too many investors place their money in the hands of a company without actually understanding how the company makes money.

The reality is that investing your money in a company you don’t understand is akin to playing no-limit poker while blindfolded. Sure, even while betting blind you can still win if everything goes your way, but it’s much easier to make money when you understand the situation.

Another red flag that we're very aware of is the company’s stock-based compensation plan, also known as their options overhang. This is the level of potential dilution a company’s earnings could suffer if all outstanding options were exercised.

As shares outstanding increases, a company's earnings are spread among more owners. Unless a company is able to offset the dilution, this is not a good thing. We always want to be fully aware of the worst-case scenario in this regard.

Ingredient #4
Don’t Lose Sight of the Big Picture

As individual investors investing in specific companies, we all have the power to build (or lose) our financial futures regardless of what happens to the overall market.

Indeed, we enjoy the freedom to step in and out of equity investments with the click of a button and a few minutes of trade execution time. Businesses, however, do not have things quite so easy.

Sometimes, even if an individual company passes all of our red-flag tests and appears to have all the factors required for prolonged success, it fails by virtue of belonging to a doomed industry.

If you disagree, take a moment to consider an example such as the typewriter industry in the early 1980s.

Just like any other manufacturing industry, there were several competing typewriter brands, each with its own market niche and competitive advantages. Some would undoubtedly be expected to outperform their peers in the coming years.

However, once personal computers from the likes of Apple and IBM burst onto the scene in the mid '80s, even the typewriter industry’s biggest heavyweights succumbed.

If a typewriter company had not invested in new technologies, its entire line-up of products and the cash they had been generating were about to become extinct.

If an investor failed to understand (or accept) the way in which information processing technology was changing at that time, a seemingly prudent investment in even the best typewriter company would have left that person with ever increasing losses.

The lesson for investors is markedly clear: understand how the bigger picture affects a company before you invest in it.

If you don’t, the macroeconomic factors you overlook could very well end up taking the wind out of your company’s sails and a big bite out of your portfolio.

The rule works both ways too; solid companies who happen to be in the right industry at the right time can turn into spectacular performers.

Ideally, we want to invest in solid companies that meet all of our company-specific criteria and also operate in industries that will grow and increase the overall markets for all of their participants.

Consider the ubiquitous online auction site, eBay, which went public in the late '90s.

This company took the notion of the typical American yard sale and combined it with the buyer and seller matchmaking ability of the internet. At the time, few people would have been able to determine how the macroeconomic outlook at the time would affect this unique company because it didn’t match any current business models.

Ebay’s business model was so unique and cutting-edge that an investor who swung for the fences with eBay stock could well have earned a tenbagger (or more).

In the case of our Undiscovered Growth and especially our Swing for the Fences portfolios, we seek to add companies that operate in truly compelling industries.

Ingredient #5
Know Thyself

With all the effort put into selecting the industries and companies in which to invest, it can be easy to lose focus of your individual financial needs. Market-beating returns are great, but if they come along too late or require a level of volatility that causes you to lay awake at night fretting, chances are your investment decisions don’t match your personal and financial needs.

At the Investopedia Advisor, we don’t just compile one list of the hottest growth stocks, and we don't invest solely in low-risk blue chip companies that pay regular dividends and see relatively little change in their share prices.

We recognize that different investors have different financial characteristics, personal situations and individual preferences.

W e aren't like the Wall Street analysts you hear on CNBC: we don't think there is a very clear a distinction between 'growth' and 'value' stocks. It makes good sense when investing legends like Benjamin Graham and Warren Buffett refer to the term 'value' investing as redundant.

Investing is all about finding an asset that is worth less now than it will be in the future, thus building in a suitable return for the investor.

That being said, you need to accurately assess your financial and personal situation and build a portfolio that is well-suited to your financial goals.

Rome Was Not Built In a Day
Far too many investors lose touch with the long-term outlook of their investments and end up betting on next quarter’s earning surprises instead of investing their savings in the long-term growth of solid companies.

If we are going to venture into stock market investments, we need to be prepared to give our chosen companies time to achieve the growth and earnings we need to realize our gains as shareholders - there is simply no way around this.

At the end of the day, by sticking to the other key ingredients of our philosophy, you can come to understand the companies you invest in, which will allow you make a more acccurate judgment about whether or not a particular investment is well-suited to your individual needs.

Ingredient #6
Avoid Conflicts of Interest

Most people who are looking to spend money on a major purchase, such as a home or automobile, don’t base their decisions solely on the advice of the commission-based salesman trying sell a product. Usually, common sense compels them to seek outside independent advice.

When it comes to making investment decisions, we need to employ this same level of common sense. Whether it's the fickle market commentators churning out news with the intent of making headlines (sometimes at the expense of providing unbiased information) or Wall Street analysts tailoring their recommendations so as not to offend their valuable corporate clients, we as investors must be wary of every single word we read.

After all, every brokerage firm in existence derives much of its revenue from investment banking operations, and public companies have good reason to give their investment banking business to brokerages whose analysts give them favorable coverage.

While not every investment banker is inherently unscrupulous, the structure of the system creates temptation. In our opinion, this is a recipe for disaster.

We don't need to search very long to find investors who would quickly agree. For example, former Enron investors put their trust in the auditing of Arthur Andersen LLP, only to watch their portfolios plummet at the discovery they had been blatantly lied to.

Or consider the plethora of investors who, in 2002, acted on the “buy” recommendations of Merrill Lynch for particular technology stocks, only to learn (after investigations by New York’s Attorney General) that these same analysts privately regarded these supposed hot picks as “junk”, “crap” and “disasters” to their colleagues and high-end clients.

I don’t know about you, but no one here has ever read about any analyst slapping a “crap” rating on a stock in the financial pages.

Wall Street’s biases and inefficiencies have been witnessed time and time again, and there is no guarantee they will not hurt investors in the future. Because of this, unbiased analysis and opinions are worth their weight in gold.

A good litmus test for the news you read is to consider its source and, more importantly, who pays that source's bills. Seek independent analysis from sources that don’t have to worry about whether the accuracy of their research will cost them clients.

Ingredient #7
Remain Confidently Contrarian

In many areas of life, once someone has achieved excellence in a chosen field, regardless of whether that person is an athlete, lawyer, musician or scholar, we fully expect that he or she will continue to excel year after year. While this assumption holds true more often than not when applied to individual expertise, it is actually quite inaccurate when applied to public companies.

Changing economic conditions, globalization, competitors’ emulations, regulatory changes and the array of organizational frictions that come with growth – these are just a handful of the factors that weigh more heavily on companies once they achieve excellence.

The odds are actually stacked against last year's outperforming stocks, and while some Wall Street darlings do continue to win, this is by no means the norm.

Unfortunately, the stock market has historically had a tendency to compound this reality by overpricing stocks with a winning record and undervaluing those with a checkered past.

Make no mistake - the market can be fickle and can become too fond of glamorous stocks that have recently yielded great profits while at the same time scorning solid companies who experience a temporary setback.

At the Investopedia Advisor, we embrace this characteristic of the financial marketplace, accept that we can’t change it and incorporate it into our analysis for the benefit of our members.

When we analyze a stock, we take the behavioral aspect of the stock market into account and steer clear of overpriced stocks that have been blessed with market popularity and overexposure.

In fact, while each of the Investopedia Advisor’s portfolios has its own unique objectives, they all focus on undervalued and overlooked stocks that are below the radar of the overall market and its analyst horde.

We believe it's best to target stocks that have yet to draw the full attention of institutional investors and Wall Street analysts because once these stocks show up on the big money’s radar and make news headlines, they tend to enjoy increased buying interest and price appreciation.

What would be an ideal stock? Well, besides measuring up to all the criteria outlined in the previous six ingredients, a company that has somehow fallen out of market favor and become undervalued for the wrong reasons would definitely warrant our interest.

These opportunities don’t come along every day (excellence is uncommon by definition), but by sticking to our contrarian guns, we believe our members can consistently outperform the market in the long run.