Sustainable Growth Rate = Return on Equity X Retention Ratio

Tips, Tricks, & Techniques

SustainableGrowth Rate.

You may forecast an earnings growth rate for the future.

There are a number of guidelines for this forecast.

One is called the Sustainable Growth Rate.

Sustainable growth rate is that rate at which the company can continue to grow, without having to borrow money or without having to issue new common stock.

This rate is a function of both Return on Equity [ROE] and the dividend payout ratio.

ROE is a measure of how well management is using stockholders money to build the company.

It compares the gains in EPS to gains in book value per share.

Dividend payout ratio is that percentage of profits paid out to stockholders. Keep in mind that every dollar paid out in dividends is one dollar less to grow the company with.

Formula: Sustainable Growth Rate = ROE * [1 - dividend payout ratio]


Example:

Company’s ROE is 20%.

Dividend payout ratio is 10%.

What is the Sustainable Growth Rate?

0.20 * [1.0 — 0.10] = 0.20 * 0.90 = 0.18 = 18%

Good guideline to determine forecast EPS: Keep forecast EPS estimate lower than Sustainable Growth Rate.

The ROE value used is the average for the last 5 years where ROE is calculated as the EPS for the given year divided by the prior year’s Book Value per Share.

The rational for calculating ROE in this manner is that this year’s EPS is the result of last year’s Book Value.


Addendum to Sustainable Growth Rate comments by Ellis Traub 

As happens so often, we can get carried away with the formulae and the numbers and lose sight of the concepts.

A company begins the year with $100 million in equity.

And, during the course of that year, it earns $15 million for a return on that equity of 15 percent.

If it retains all of what it earned, the equity will have grown 15 percent.

And, since the company was able to make 15 percent on its equity, those retained earnings should also be able to earn 15 percent in the next year.

Similar to compounding, this shows that the sustainable growth, just the growth produced by those retained earnings, be 15 percent.

Companies aren't restricted from growth above that rate. They use a variety of resources to increase or perpetuate a higher rate.

They include leverage (using other people's money) to acquire the assets that generate more revenue, or they sell more shares.

While those shares might dilute the EPS, they were sold not given away, so they do add to the equity of the company.

Acquiring productive assets, acquiring operating companies, etc. are only a few of the things that managements, or directors, commonly do to exceed the sustainable growth rate.

So, of what interest is it to us?

 It's just a simple metric that tells us that, without doing these other things, the company can still grow at that rate. 

The only thing that might keep the ROE, sustainable growth, and earnings growth from being the same is the prospect of not using all of those earnings to produce more but, instead, to pay out some of those earnings in dividends. 

This, of course, would reduce the amount of money that is available to earn more; and it will, therefore, cut down the sustainable or implied growth rate. 

Otherwise, if dividends are not paid, the ROE and earnings growth rate will be the same, as will Implied growth.

If earnings growth falls, so will the ROE.

This formula (Implied growth = ROE * RR) [RR=Retention ratio, the percent of earnings NOT distributed to shareholders] will not work if you use ending or average equity.



http://naicspace.org/pdf/sustainablegrowthrate.pdf


STOCK FUNDAMENTALS By Ellis Traub USING ROE TO ANALYZE STOCKS: WHAT YOU NEED TO KNOW ABOUT
http://www.aaii.com/journal/article/using-roe-to-analyze-stocks-what-you-need-to-know-about

Asset value (AV) and Earnings power value (EPV). Know the 3 scenarios - AV > EPV, AV = EPV and AV < EPV

What you have got then is two pictures of value: 

1. You have got an asset value
 2. You have got an earnings power value
 
And now you are ready to do a serious analysis of value. If the picture looks like case A (AV > EPV), what is going on assuming, you have done the right valuation here? If it is an industry in decline, make sure you haven’t done a reproduction value when you should be doing a liquidation value.  What it means is say you have $4 billion in assets here that is producing an equivalent earnings power value of $2 billion. What is going there if that in the situation you see?  It has got to be bad management.  Management is using those assets in a way that can not generate a comparable level of distributable earnings.  

AV is Greater Than EPV 

• In this case the critical issue—it would be nice if you could buy the company—but typically you pay the reduced EPV and all that AV is sitting there.
• Then you are going to be spending your time reading the proxies and concentrating on the stability or hopefully the lack of stability of management. 
• Preeminently in that situation, the issue is a management issue. 
• The nice thing about the valuation approach is that it tells you the current cost that management is imposing in terms of lost value.  That is not something that is revealed by a DCF analysis. And there are a whole class of value investments like that.
• One of the great contributions to the theory of this business is Mario Gabelli’s idea that really what you want to look for in this case is a catalyst that will surface the true asset value.
• You can wait and sometimes that catalyst may be Michael Price or Mario Gabelli if they own enough of the company.  I would like to encourage those investors who are big enough to make that catalyst you.  

AV Equals EPV 

• The second situation where the AV, the reproduction value of the assets = EPV are essentially the same.
• That tells a story like any income statement or balance sheet tells a story.  It tells a story of an industry that is in balance.  
• It is exactly what you would expect to see if there were no barriers-to- entry. 
• And if you look at this picture and then you analyze the nature of the industry—if you say, for example, this is the rag trade and I know there are no competitive advantages—you now have two good observations on the value of that company. 
• If it ever were to sell at a market price down here, you know that is what you would be getting. You are getting a bargain from two perspectives: both from AV & EPV so buy it. 

EPV in Excess of AV 

• We have ignored the growth, but I will talk about it in a second#. The last case is the one we really first talked about. You have got EPV in excess of AV. 
• The critical issue there is, especially if you are buying the EPV—is that EPV sustainable?
• That requires an effective analysis of how to think about competitive advantages in the industry.

Introduction to a Value Investing Process by Bruce Greenblatt at the Value Investing Class Columbia Business School 
Edited by John Chew at Aldridge56@aol.com                           
studying/teaching/investing Page 26

 Notes from video lecture by Prof Bruce Greenwald
http://csinvesting.org/wp-content/uploads/2012/06/greenwald-vi-process-foundation_final.pdf



Related topic: #
Look at growth from the perspective of investment required to support the growth. Profitable Growth Occurs Only Within a Franchise.

5-Year Closing Price. Can this be predicted?

Be rational in facing market uncertainties.

Many good quality growth stocks have a price pattern quite similar to the above chart.  Many have even rebounded to reach their old highs or new highs.

U.S. economy: From Recovery to Sustainable Growth

July 15, 2010, 10:21PM EST

Analysts Pare Revenue Growth Expectations

Investors may not be able to count on robust rates of sales growth to boost earnings in coming quarters

By David Bogoslaw

Equity analysts and investment strategists have been closely watching corporate revenue trends since last summer to see what's driving any improvement in earnings. But investors may not be able to count on improving sales growth as a way to pump up profits: Analysts are dialing back expectations for revenue growth for some of the world's biggest companies.

In a July 13 market commentary, Nicholas Colas, chief market strategist at BNY ConvergEx Group, an investment technology provider, published data showing that analysts' consensus revenue estimates for the 30 stocks in the Dow Jones industrial average for the second, third, and fourth quarters of 2010 have been declining since April or May. Forecasts were lower in July than in April or May for 21 companies of the Dow 30 for the second quarter, for 22 for the third quarter, and for 19 for the fourth quarter, the report said.

The trend toward lower revenue expectations is present in the broader market. In the three months leading up to July 15, 48.7 percent of companies in the Standard & Poor's 500-stock index with available data had their revenue estimates cut, vs. 39.3 percent in the comparable period leading up to Apr. 30 and 37.1 percent in the three months leading up to Jan. 29, according to Bloomberg data. The start of fourth-quarter earnings releases is typically mid-January, while first-quarter earnings are released beginning in mid-April.

Colas has been tracking analysts' projections for revenue growth for the past year and says that until April those numbers had continued to climb "every single month, month in and month out," reflecting analysts' expectations for further improvement in quarterly earnings. But the trend over the past two months has flattened and is now declining. That's coincided with an 8.0 percent pullback in the S&P 500 index between Apr. 15 and July 15, and Colas believes there's a link between the two.

"For the first time since the [March 2009] market lows, analysts now realize they have overshot on revenue expectations and now are starting to pull them back in," he says. "Earnings expectations have not declined, so analysts have cut revenue expectations but have given companies more credit for [continuing] cost cuts."

IMPACT ON STOCKS
Doubts about the strength of revenue growth over the past year could pose problems for continuing advances in stock prices. "What do you pay for earnings if you're not sure what the structural growth rates are? That's a big, big question," says Colas. "One proxy for structural growth is revenue growth."

While two-thirds of the 30 Dow components seems like a large proportion, the index contains a lot of blue chip companies whose sales are highly correlated to U.S. gross domestic product, says Jeffrey Kleintop, chief market strategist at LPL Financial in Boston. As GDP projections for 2010 have moderated, it makes sense that consensus estimates for revenue growth would follow suit, he says. On July 14, the Federal Reserve lowered its economic growth estimate for 2010 to 3 percent to 3.5 percent from a forecast of 3.2 percent to 3.7 percent given in April.

It's fair to wonder whether the increasing percentage of downward revisions reflects the extent to which analysts may have been blindsided by the European sovereign debt crisis and the slowdown in China, not to mention the soft patch that the U.S. economy has hit. It may be that analysts' optimism about economic growth at the start of a new year tends to fade as the year wears on, which is borne out by patterns in 2009 and so far in 2010, says Peter Nielsen, manager of the Sextant Core Fund (SCORX) at privately held Saturna Capital in Bellingham, Wash.

Another thing to keep in mind: "There's a lot of noise" in the year-over-year comparisons for revenue due to the absence of growth drivers such as cash for clunkers and other government stimulus programs that boosted companies' sales in 2009, says Nielsen. That may be one reason for the conservative revenue numbers coming from many brokerage analysts, he adds. Nielsen thinks year-over-year comparisons will become more difficult as the year progresses and expects "very modest" revenue gains in the third quarter.

It also makes sense that analysts would be paring their revenue estimates around the one-year anniversary of what most economists agree was the bottom of the economic cycle, says Craig Peckham, equity product strategist at Jefferies & Co. (JEF). It's logical to conclude that revenue growth will disappoint investors as year-over-year earnings comparisons become more challenging later this year, he says.

REASSURING EARNINGS REPORTS
The central issue is that investors are unwilling to pay as much for earnings growth driven more by cost-cutting than by improvement in sales. "What you pay for an earnings multiple for cost-cutting is less than what you pay for revenue growth because cost-cutting has to stop somewhere" while revenue growth has "a longer runway," says Colas.

Encouraging second-quarter earnings reports may be enough to stanch the flow of negative revisions and confirm the view that analysts have reduced estimates too far on concerns about Europe, as well as doubts about consumer spending in the U.S., says Jefferies' Peckham. The performance of some equity market bellwethers seems to suggest that analysts may be relying too heavily on pessimistic macroeconomic data that have come out in the last two months, he adds.

Alcoa (AA) reported earnings of 13 cents per share on July 12, beating the Street's forecast by a penny, on a 22.2 percent rise in revenue from a year earlier. On July 13, Intel (INTC) posted a profit of 51 cents per share, up from 18 cents a year earlier and beating analysts' expectations by 8 cents. The microchip manufacturer's revenue rose $2.7 billion, or 33 percent, from a year earlier, exceeding the consensus forecast by $549.9 million, or 5.5 percent. Intel projected third-quarter revenue of $11.2 billion to $12 billion, the lower range of which was ahead of the consensus estimate by $289.35 million, or 2.7 percent, a day prior to the earnings release.

In making the transition from recovery to sustainable growth, the U.S. economy faces some key obstacles such as Europe's fiscal problems and the weak domestic labor market, according to a midyear outlook report by LPL Financial published on July 12. While U.S. banks are fairly insulated from European debt woes, LPL said that U.S. exports and business spending are vulnerable to a pullback in global economic growth that could result from another freeze of liquidity and trade, as well as to the euro zone slipping back into recession due to cuts in government spending, tax hikes, and higher borrowing costs.

TYPICAL RECOVERY SLOWDOWN
Kleintop thinks analysts were caught by surprise by negative macroeconomic data on home sales, retail sales, and job creation. That's not unusual since analysts tend to focus more on microeconomic data related to companies they cover than what's happening in the broader economy. But the fact that the economy has hit a soft patch a year into the recovery is typical of each of the past several recoveries, he says. Each time, the soft period didn't halt the expansion, but it did slow the pace of economic growth and result in a flat stock market for about a year, he says.

Another source of confusion for the market is the divergence between robust manufacturing data and a resurgence of caution among consumers. While the manufacturing strength is encouraging, that's a small part of the economy relative to consumer spending, which accounts for roughly 70 percent of GDP. The fact that the dominant sector is so sluggish "makes this recovery somewhat fragile and susceptible to a downside shock," says David Joy, chief market strategist at RiverSource Investments. He thinks consumer spending will probably remain soft, making a 3.0 percent gain in GDP the best the U.S. can muster for the foreseeable future.

It's worth noting how questions about economic growth have been translating into stock performance, he says. "We're noticing valuations within the market are very compressed. Investors are saying large caps are no better than small caps, that high-quality stocks are no better than low-quality ones," he says. "That tells us where you want to be is in large-cap, high-quality stocks," which have more reliable earnings growth and tend to pay dividends and aren't selling at a premium to lesser-quality names as they usually would.

But by focusing on revenue growth, investors may be overly conservative in their outlook for earnings growth. U.S. companies slashed costs dramatically at the bottom of the cycle, paving the way for outsized earnings growth once revenues recover even modestly, says Peckham. "Companies have been able to create cost structures with a ton of operating leverage. If you've got a model with good operating leverage, your earnings should go up a lot faster than your revenues," he says.

CORPORATE OUTLOOK WATCH
Second-quarter earnings, which have just begun to be reported, are likely to ease market jitters as key economic questions such as the impact of Europe's debt and growth problems are put in perspective, says Kleintop. Although many companies in the S&P 500 export goods and services to Europe, most of the demand from overseas in the past year has come from Asia. Large U.S. companies can still generate strong double-digit profit growth without help from Europe, he says.

Saturna's Nielsen is particularly eager to hear comments from pharmaceutical executives on earnings conference calls to get a sense of the impact they expect fiscal austerity measures in Europe to have on their European sales. He's deeply skeptical of the confidence sell-side analysts have in European governments' willingness to continue to pay up for drugs and joint replacements based on aging demographics in those countries, in the face of their fiscal difficulties.

Conference calls should also provide more clarity on the tangible costs of health-care and financial reform as companies disclose what they think the impact of these regulatory changes will be on their businesses, says Kleintop. "Once you can define them, they start to lose some of their potency to sway sentiment," he says. That could help sustain the recent stock rally. While the market seems stuck in a broad range, he says the S&P 500 could see further gains of 5 percent to 7 percent before another round of profit-taking kicks in.

The increasing number of downward earnings revisions doesn't bode well for stock market gains in 2010 relative to 2009. Roughly 200 companies in the S&P 500 have had downward revisions in the past three months, vs. 250 that have had upward revisions, according to data that Kleintop has been watching. Three months ago, only 150 companies had had downward revisions vs. 300 that had had upward revisions. The percentage of total analyst revisions that are positive "moves in lockstep with the year-over-year performance of the S&P [500 index]" going back 30 years, he says.

The steam that's come out of revenue growth expectations makes the 2011 consensus forecast for aggregate earnings of $96 per share for the S&P 500 look less and less realistic, says RiverSource's Joy. With the broad market now trading at around 12 times that number, even if you scale revenue growth back slightly, stocks still seem inexpensive, he says. That makes him think there's a cushion for equities even if revenue growth isn't robust enough to generate the earnings analysts are expecting.

Bogoslaw is a reporter for Bloomberg Businessweek's Finance channel.

http://www.businessweek.com/print/investor/content/jul2010/pi20100715_477248.htm

Buffett (2000): The risks associated with the twin issues of CEO's lofty projections and sustainable long-term profit growth.

Warren Buffett talked about wealth transfers to greedy promoters during IPOs in the letter for the year 2000. Let us go further down the same letter and see what other investment wisdom the master has to offer.

The master's macro bet

Usually, Buffett refrains from making precise comments about the future especially at the macro level. But if he is willing to bet a large sum on the likeliness of an event happening, then indeed we must sit up and take notice. In the letter for the year 2000, the master has made one such prediction and was willing to bet a large sum on it. The prediction was about the magnitude of growth in profits that would take place among the 200 most profitable companies in the US at that time. Since the master does not believe in short term predictions, the time horizon that was assumed was ten years.

The CEO with a crystal ball

The letter for the year 2000 came out at a time when the practice of a CEO predicting the growth rate of his company publicly was becoming commonplace. Although Buffett did not have an issue with a CEO setting internal goals and even making public some broad assumptions with proper warnings thrown in, it did annoy him when CEOs started making lofty assumptions about future profit growth.

This is because the likelihood of the CEO meeting his aggressive targets year after year on a consistent basis and well into the future was very low and hence this amounted to misleading the investors. After having spent decades researching and analyzing companies, the master had come to the conclusion that there are indeed a very small number of large businesses that could grow its per share earnings by 15% annually over a period of 10 years. Infact, as mentioned in the above paragraph, the master was even willing a bet a large sum on it.

The reasons may not be difficult to find. In free markets, the intensity of competition is so high that it is very difficult for profitable players to maintain high growth rates for consistently long periods of time. Unless the business is endowed with some extremely strong competitive advantages, competition is likely to nibble away at its market share and cut into its profit margins, thus making high growth rates difficult.

Let us hear in the master's own words his take on the twin issues of

• CEO's lofty projections and 
• sustainable long-term profit growth.

The golden words

"Charlie and I think it is both deceptive and dangerous for CEOs to predict growth rates for their companies. They are, of course, frequently egged on to do so by both analysts and their own investor relations departments. They should resist, however, because too often these predictions lead to trouble."

He further adds, "It's fine for a CEO to have his own internal goals and, in our view, it's even appropriate for the CEO to publicly express some hopes about the future, if these expectations are accompanied by sensible caveats. But for a major corporation to predict that its per-share earnings will grow over the long term at, say, 15% annually is to court trouble."

The master reasons, "That's true because a growth rate of that magnitude can only be maintained by a very small percentage of large businesses. Here's a test: Examine the record of, say, the 200 highest earning companies from 1970 or 1980 and tabulate how many have increased per-share earnings by 15% annually since those dates. You will find that only a handful have. I would wager you a very significant sum that fewer than 10 of the 200 most profitable companies in 2000 will attain 15% annual growth in earnings-per-share over the next 20 years."

Adding further, the master says, "The problem arising from lofty predictions is not just that they spread unwarranted optimism. Even more troublesome is the fact that they corrode CEO behavior. Over the years, Charlie and I have observed many instances in which CEOs engaged in uneconomic operating maneuvers so that they could meet earnings targets they had announced. Worse still, after exhausting all that operating acrobatics would do, they sometimes played a wide variety of accounting games to "make the numbers." These accounting shenanigans have a way of snowballing: Once a company moves earnings from one period to another, operating shortfalls that occur thereafter require it to engage in further accounting maneuvers that must be even more "heroic." These can turn fudging into fraud. (More money, it has been noted, has been stolen with the point of a pen than at the point of a gun.)"

Valuation of KNM and Sustainable Growth Companies

In the absence of clarity in future earnings, very low NTA and significant debt, how does one value KNM?

? 10 sen / share

A quick look at KNM
http://spreadsheets.google.com/pub?key=tnYPvXKu8my2Fsri8qR60oA&output=html


A related story:

One-time events that help grow companies for a short period usually affect prices significantly, but such changes are often temporary.

In the mid-1970s, again in the mid-1990s, and once again in the mid-2000s when oil prices went up quickly, many companies supplying oil-drilling services became high-growth companies.  However, they could not sustain their growth.

For example, Global Marine, an otherwise well-managed company, was trading at around $35 per share in late 1997, but oil prices went down in 1998, and Global Marine's stock price quickly retreated to less than $8 per share.  

A careful investor looking for an outstanding long-term growth company would have avoided Global Marine because the growth was from a one-time event.

It was and can be difficult to know which companies would have sustainable growth.

On the other side, note that at the time of going public, even Microsoft was not an outstanding growth stock because it was not clear that the company could sustain its growth.  However, over time, it became clear that Microsoft's products were immensely successful.  Microsoft was a near monopoly, and the number of customers for those products would increase for many years to come.  At that point, it was a good growth stock worth investing in.

The Quest for Sustainedable Earnings Growth

The Quest for Railroad-Track Growth
Often a Sign of Good Management, Sometimes Too Good to Be True

by Michael Maiello

Sustainable earnings growth is a Holy Grail sought by investors of all stripes. Value investing guru Benjamin Graham searched for it, choosing stocks based in part on a management team’s ability to generate an upward trend in earnings over many years. Graham was a bit accommodating with this requirement; he’d tolerate flat earnings for a year or two so long as it didn’t look as if earnings were about to break through the floor. He believed stock prices eventually would track growing earnings over time.

Growth investors expect more. BetterInvesting members look for companies that have a consistent history of producing better-than-average earnings growth. In innovation-based industries such as pharmaceuticals and technology, this can often mean double-digit earnings growth even as stocks in the broader market are buffeted by recession.

The managers of the U.S. Trust Focused Large-Cap Growth Fund explain the strategy this way: “Emphasis is placed on selecting high-quality companies having dominant industry positions, strong financials and consistently high earnings growth rates. Such companies tend to be brand name, globally dominant companies in open-ended growth industries such as devices/biotech/ genetics, information technology, global consumer brands and global financial companies.”

Consistent earnings growth implies that a company is in a position to maintain dominance and has the management team to do it. A good example is Johnson & Johnson. Its five-year earnings growth rate is 13.8 percent a year, creating enough steady increases to fund 14 percent growth in dividends over that time and more than 20 percent return on equity. J&J has a diversified product line across pharmaceuticals, home products and consumer goods. Its ability to distribute products around the world is difficult for competitors to match much less beat. This seems to be a company where the past growth is indicative of good management and a dominant market position. (Companies are mentioned in this article for educational purposes only. No investment recommendations are intended.)

Apple has grown earnings at well over 100 percent annually for the last five years, an amazing run as new products such as the iPod and iPhone were brought to market and then allowed to mature. These are widely acknowledged as the products of Steve Jobs’ genius, or at least of the culture of design he implemented and fostered during his tenure at the company. A lot of companies had MP3 players and smart phones before Apple, but only Apple made them cool.

But the Apple example brings us to the pitfall of this style of investing. Apple isn’t exactly like J&J. Apple has a good number of larger competitors (such as Sony and Microsoft) that can, and often do, undersell it. Also, fads change, so although Apple’s proven ability to remain in style is nice to know, investors can’t count on it. Look at what happened to The Gap, which was once a hot brand but hasn’t been in a decade.

Another concern is that consistent earnings growth is extremely hard to produce, so investors should try to learn more when seeing 15 percent growth year after year. Enron is among the most notorious examples of this principle. Between 1997 and 2000 the company’s management team somehow beat analysts’ earnings estimates more than three quarters of the time, an amazing feat we now know was made possible by accounting shenanigans that kept losses and liabilities out of the picture. Enron’s managers were also masters at inorganic growth — boosting earnings through acquisitions and asset sales rather than by improving fundamentals in its business.

Finally, watch out for “earnings smoothing,” the term academics and regulators use to describe cases in which company managers adhere strictly to the letter of generally accepted accounting principles, or GAAP, but not quite to the spirit of it. Some have charged that financial firms used loopholes and oversights in the complicated body of GAAP rules to consistently understate losses and potential losses they faced from subprime mortgage exposure early in the credit crisis. This explains why, as the crisis unfolded, there seemed to be so many new surprises from companies that had supposedly come clean.

One rule of thumb: If the earnings growth doesn’t have a simple explanation behind it, as in the case of, say, J&J, Wal-Mart or Apple, at the very least be skeptical.

BetterInvesting’s Online Tools

The Stock Selection Guide, the primary stock study tool of BetterInvesting members, helps you identify stocks with histories of sales and earnings growth. Our new online tool will walk you through evaluating a company using the SSG. Click on the Online Tools & Software link under the Tools & Resources menu on the BetterInvesting homepage. Your membership may already include access to the tool; if not, you can upgrade your membership to use it.



Michael Maiello, who wrote "Fly With the Fundamentals" for the January 2006 issue, is the author of Buy the Rumor, Sell the Fact (McGraw-Hill, 2004).

http://www.betterinvesting.org/Public/StartLearning/BI+Mag/Articles+Archives/0809fundamentalpublic.htm

5 Traits of Great Stocks

5 Traits of Great Stocks
By Jeff Fischer
June 15, 2009

A recent study revealed that three of four stocks on the U.S. markets lost value between 1980 and 2008, despite the S&P 500 returning 10.4% annualized. What this means is the winning stocks won big, thereby compensating for the overwhelming number of losing stocks. However, if you hope to be invested in the winners, you need to choose carefully.

More than two decades of investing experience has helped us at Motley Fool Pro zero in on what makes for a winning business. Here are five of the key traits we seek in each stock before we buy it.

1. Sustainable competitive advantage
Healthy profits in a business attract competition -- everyone wants a piece of the profit pie. The only way a company can maintain profit margins and grow is to have a sustainable competitive advantage that serves as a protective moat around the business. You hear this quality talked about often, from Warren Buffett on down, but many investors still fail to buy companies that sustainably meet the bill. That's because it's the rare company that truly has lasting advantages -- but they are out there.

They're usually midsized or larger, have a long history of steady growth, and own assets or market share that provide enduring advantages over all others. Think Cameco (NYSE: CCJ), the largest uranium owner on the planet (the world isn't producing more uranium anytime soon); or Intel (Nasdaq: INTC), which enjoys 80% market share in computer CPUs. eBay (Nasdaq: EBAY) has sustainable competitive advantages, but it hasn't evolved quickly enough to keep all of its customers happy. However, network effects and market share -- competitive advantages -- are buying it time to right the ship.

2. Diverse customer base
A competitive advantage isn't worth much if the business is dependent on only a few customers. We like our businesses to have widely diverse and growing customer bases. This way, when some customers are lost, the business is not in peril and will continue to grow. We shy away from buying companies where just one or two customers account for 10% -- or more -- of annual sales.

3. Pricing power
With a lasting competitive edge and a broad customer base, a company usually enjoys some degree of pricing power. When costs rise, the company can pass them on to customers rather than suffering them itself. The strongest companies can implement modest price increases every few years without losing or alienating customers. Pricing power gives a company one more important arrow in its quiver as it hunts for long-term annualized growth.

4. Significant recurring revenue
If a business enjoys our first three criteria and also has significant recurring revenue, we become even more interested. By recurring revenue, we mean sales that repeat all but automatically, often with the same customers again and again, and usually without the company needing to spend more on marketing or reinventing itself or its products.

Revenue at the largest electronic exchange in the world, Nasdaq OMX (Nasdaq: NDAQ), recurs whenever someone makes a stock or option trade on its exchanges. Elsewhere, insurance companies enjoy recurring revenue every time a policy is auto-renewed, which happens more than 80% of the time at the best providers. Software companies have also gotten wise and sell annual subscriptions to their wares.

As General Motors collapsed in the first major recession in years, we're reminded that automakers are an example of anything but easy recurring revenue. They need to advertise continually to drive each sale, making for an expensive business that's vulnerable when the economy stumbles.

Easily or "naturally" recurring revenue results in more predictable and more profitable results, and helps maintain a business even during recessions. Some of the stocks we buy in Pro won't have naturally recurring revenue, but when it drives at least 30% of annual sales, the company gets a close second look from us.

5. Expanding free cash flow
The qualities we've mentioned so far will usually lead to strong free cash flow, which is the lifeblood of any company. By definition, free cash flow is cash from operations minus capital expenditures and any other nonoperational cash income, such as tax benefits from stock options. Much more reliable than mere earnings per share numbers, we're looking for free cash flow that's growing at least 8% to 10% annualized over the long term.

No company grows in a straight line, but over time we want expanding free cash flow to drive the value of the businesses we own. Strong free cash flow growers over recent years include software provider Oracle (Nasdaq: ORCL) and credit card giant MasterCard (NYSE: MA). Meanwhile, a rebound in free cash flow can revitalize a company, as has happened with BMC Software (NYSE: BMC) since 2004, more than doubling its share price. All three companies, incidentally, also enjoy all of the four traits above.



http://www.fool.com/investing/general/2009/06/15/five-traits-of-great-stocks.aspx

Good growth is profitable, organic, differentiated and sustainable.

Good growth is profitable, organic, differentiated and sustainable.

Profitable

Good growth is profitable.

It is also capital-efficient, that is, it needs to earn a return on its investment greater than what the company could have received by putting its money in something ultra-safe, such as a Treasury bill.

There is growth in revenues and steady improvement in profitability. Gross margin is an important indicator of a company's profitability and often not given the due it deserves.

Increasing gross margin and at the same time growing revenues at a rate better than the overall market is what makes for a great growth company. There is a direct relationship between improved productivity and profitable growth.

The improvement in gross margin also reflects the company's ability to innovate ahead of its competitors.

A company's rapid growth attracts the best managers in the industry - managers who are committed to growth.

Organic

Organic growth is the most efficient way to create revenue growth.

When people work with customers in the search for new ideas, translating those ideas into reality requires them to cut across silos and come together to make trade-offs and decisions in launching new products. It also builds the organization's self-confidence. Knowing that it has created a successful growth project makes it easier to tackle the next challenge, and the momentum feeds on itself.

Organic growth can also be based on filling an additional customer need and/or exploiting an organization's existing expertise in products, customer segments, or geographic regions, to capture new markets.

While good growth is PRIMARILY organic, there are times when it makes sense to supplement organic growth with smaller "bolt-on" acquisitions to fill strategic gaps, such as gaining a beachhead in a geographic region, obtaining a new technology, filling an adjacent need, or adding a new distribution channel.

Differentiated

No matter how "commoditized" your business is, good-growth companies find a way to differentiate themselves.

Winners in the quest for profitable growth pay attention to differentiation, however razor-thin.

To do that, they see things through the eyes of their customers and potential customers, detect what these buyers prefer, and hook the customer through products, services, and relationships that are better differentiated than those of the competition.

Dell offers a commodity: personal computers. Yet Dell differentiated its product line by making sure its product are reliable, low-priced, and customizable - that is, customers can design their PCs exactly the way they want.

Lexus truly differentiated itself in the post-purchase experience and in mechanical reliability.

Differentiation can also take place in the service that a manufacturer provides to retailers like Wal-Mart. By helping the customer increase its sales, the manufacturer has differentiated itself from being just another firm that the customer does business with.

Sustainable

Good growth continues over time. It has a sustainable trajectory.

It is not a quick spike upward in revenues, caused by cutting prices or by throwing substantial resources against a one-shot opportunity. The goal is to have the growth continue year after year.

-----

The only way this growth is going to occur is if everyone in the organization believes in it to be possible. It is up to the organization's leadership to create the right mind-set.

Sustainable Growth

Sustainable Growth



Good growth continues over time. It has a sustainable trajectory. You are NOT looking for a quick spike upward in revenues, caused by cutting prices or by throwing substantial resources against a one-shot opportunity. The goal is to have the growth continue year after year.



For example, the growth of Southwest Airlines has been based on a consitent set of actions. New routes are carefully vetted - the goal is to have them be profitable in less than a year - and turnaround times (the period from when a plane pulls into a gate until it pushes back on another flight) are substantially faster than the industry average, allowing Southwest planes to fly more trips a day than its competitors.



If you look at one of the suppliers to the airline industry, you can see another example of sustainable growth. In this case, the move toward sustainability was prompted out of necessity.



When the airline industry declined in the early 1990s, it led to a decerease in the revenues of firms that sold aircraft engines. GE Aircraft Engines redefined the needs of its airline customers to include not just the engines themselves but also servicing them on a regular basis. Up to that point, a major airline would use the service shop of one company in, say, Chicago and that of completely different companies in its other locations around the world. Some also did the service themselves in their own shops.



GE's new value proposition was to provide total service around the globe. Through innovation, use of information technology, and managerial ability to provide better maintenance, the result would be less downtime for the airlines and lower costs.



For example, doing a major overhaul on its own might have required an airline to fly its plane back empty to its service facility. With service operations around the world, GE can do the work wherever a plane is, which gets the plane back in the air, generating revenues sooner. And because it specialises, GE can do the necessary service work faster, increasing productivity for the airlines once again. Scores of airlines took advantage of the chance to outsource the maintenance part of their business to a single supplier.



Before its chief competitor, Pratt & Whitney, woke up, GE Aircraft Engines captured 70% of the airplane-service market. And, of course, the service contracts tied customers more closely to GE, giving it a leg up in selling the core product -engines - and developing a sustained trajectory of growth by having a built-in-revenue stream, the money that comes in month in and month out from the service contracts.



In this case, the "single" and "double" of adding a service coponent to a product created a platform that is a home run in terms of a sustained, decades-long trajectory of growth. The recurring revenues from the service work are extremely reliable. Not only has GE Aircraft Engines otgrown the competition - its model of adding service to products became a best practice for other GE businesses, which are now adding high-margin service work into their product mix.



It is also an example of building both scale and scope and then learning how to leverage for growth. GE Aircraft's number-one position in the marketplace, combined with organic growth and simultaneous productivity, gave it the leverage to make acquisitions in the service area.



But the only way this growth is going to occur is if everyone in the organization believes it to be possible. It is up to the organization's leadership to create the right mind-set.