How do you spot winning stocks? You can find them by a number of special traits.
ResMed Inc. (CHESS) (ASX: RMD) and SEEK Limited (ASX: SEK) are great examples of winning stocks. See how they match the following three signs of winners. Then, you can use those signs as part of a checklist to identify other winners among the thousands of stocks to choose from on the ASX.
1) It makes more money than it needs
You can look at a company's income and spot a winner by its net profit margin and the excess cash it spins off. If a steel company brings in a billion dollars in revenue, but spends $950 million in the process, the profit margin gets thin.
Or if re-tooling and buying machinery just to keep the business from becoming obsolete burns up cash, there won't be a lot of excess cash flow for special business development, paying down debt or returning capital to shareholders.
ResMed is in the healthcare sector where products affect the quality of life of customers and patients, so its effect is special on them. Its breathing aids and respiratory devices generate net profit margins in the high teens or low 20s consistently every year. Its excess cash flow also allows it to put a lot of money towards product research and development. That keeps new products coming onto market and maintains its earnings growth.
2) It has products or services that customers are willing to pay up for
Not every product or service may be a household name, but specialised features and high quality make them stand out. What makes a Gucci bag or Rolex watch so desirable?
You can spot winners again by high profit margins and return on equity.
SEEK Limited operates the highly successful seek.com.au job search website. It's the site where the majority of job hunters go to. Many employers and employment recruiters list jobs where they think the most job candidates can be found. That keeps the site number one by far and it can charge a premium for its services and jobs listings.
The company regularly has underlying net profit margins in the low to mid- 20s. Its return on equity has been 19% – 31% in the past five years. Average companies may be around 8% – 12%.
3) It doesn't load itself up with too much debt
Even successful companies can get stuck here. Some debt can be good for developing a business, but when it's too high, it can make the company fragile. High interest payments chew up potential profit. Also, if debt can't be paid properly, then the whole business is in jeopardy.
ResMed had $319 million in long-term debt in FY 2014, yet its underlying net profit alone for that year was $373 million. It could pay all its debt off with one year's earnings if it wanted to.
SEEK had $379 million of long-term debt and underlying net profit of $170 million in FY 2014. That's less than three times debt to profit. I want to see less than five times to feel comfortable with a stock. SEEK is a fast growing company, so it may take on more debt to finance that growth.
