These are the six fundamental characteristics that correlated most highly with profits in a 10-year study of stocks bought for the Model Portfolio of the Cabot Growth Investor. In other words, these are the factors that were best at bringing us profits.
1. Excellent, innovative management
Henry Ford, Thomas Watson, Ray Kroc, Jack Welch, Walt Disney, Akio Morita, Sam Walton, Bill Gates, Larry Ellison, Steve Jobs, Meg Whitman, Jeff Bezos, Martha Stewart, Craig Venter and Dennis Kozlowski (for a while) were all great managers who led their companies to success by thinking differently. Admittedly, there is no hard and fast measurement of management talent, but because this is the most important characteristic of all—and we think it always will be—it’s worth thinking about very hard. Most managers are nowhere near as good as those legends. But when you find a top manager—especially one with a record of prior successes—you should give him or her a little extra leeway. Top managers have a way of overcoming obstacles through a combination of vision, enthusiasm and leadership.
2. High profit margins
Software companies tend to have very high margins because they deal in code that costs nothing to ship or store, while iron ore companies tend to have very low margins. In recent decades, high-margin stocks have trounced low-margin stocks. But with the recent strength of companies dealing in steel, potash, coal and other bulk commodities, the times may be changing.
3. Triple-digit revenue growth
In our experience, companies growing revenues at triple-digit rates (100% or better) tend to be small and less well known; thus they’re ripe for buying by institutions as they grow.
4. Accelerating earnings growth
There’s no ambiguity here. If a company’s earnings growth rate (measured by comparing the earnings of one quarter to the earnings of the same quarter in the prior year) increases for two quarters in a row, growth is accelerating. In general, faster growth is better growth, and a company whose earnings growth rate is accelerating (whether it’s due to increased revenues or more efficient operations) is becoming an increasingly attractive investment. Acceleration tends to be under-appreciated by investors (some just don’t see it), so buying when you first recognize it usually works out very well.
5. Market dominance/barriers to entry
Patents often provide a great barrier to entry. And if there’s no one else providing competition, you can be sure those patents are strong. Intuitive Surgical (ISRG), for example, has been a great winner, partly because it has no competitors. As for market dominance, this can be harder to measure. GameStop (GME), for example, is by far the biggest retailer of video games in the U.S. But with just 23% of the market, is it dominant? Intelligent minds can disagree.
6. Huge mass markets
This one is well known to many investors. The more potential customers there are for a product or service, the greater the possibility that the business will be a success and the greater the possibility the investment will be a success. But how big is a mass market? Sometimes it’s hard to know where to draw the line; there is no right answer. Choosing between a manufacturer of curling equipment (that sport where they slide the rock down the ice) and a manufacturer of shoes, we’d go with the shoe manufacturer.