These Three Clues Will Lead You to Your Next Big Winner

Editor's note: Free cash flow and a history of rewarding shareholders...

Those are two of our colleague Dan Ferris' "five financial clues" for finding your next great investment.

In today's Masters Series – adapted from a 2013 series of DailyWealth essays – Dan reveals the final three clues... talks about the upside of having a lot of debt... and explains how these clues can help you find investments that let you sleep at night...

These Three Clues Will Lead You to Your Next Big Winner

How much cash would it take for you to feel "secure"?

What if, after paying all your expenses every year, you still had nearly $200,000 to spend however you wanted? Would that make you feel financially safe? Or what if you had enough cash to cover your mortgage five times over? Would that be enough?

Not a lot of folks are that cash-rich. A lot of companies aren't like that, either.

But I've assembled a short list of high-quality companies that have "fortress" balance sheets. They either have so much cash... or generate so much cash every year... there's very little chance they'll ever run into any financial problems.

And these "sleep at night" companies still have tremendous upside potential...

Yesterday, I showed you two of the most important "clues" I use to uncover the world's greatest investment opportunities: the amount of cash flow a company generates and how it uses that cash to reward shareholders.

The third clue I look for when choosing a great investment is: a great balance sheet.

The balance sheet is a financial statement that shows a company's assets and liabilities. Assets are what it owns, and liabilities are what it owes.

There are two kinds of great balance sheets we look for when finding a company that could potentially double or triple your money.

The first is a balance sheet with an enormous amount of cash and relatively little or no debt. You can recognize a company like this in 30 seconds or less.

The best example is iPhone maker Apple (AAPL)...

Apple has more than $261 billion in cash and securities. And it has $108 billion in debt. That's a lot of debt, but it's nothing compared to the amount of cash Apple has. Apple could pay off all its debt and still have $153 billion in cash left over.

Imagine having almost two and a half times as much cash as the debt you have on your home, car, and credit cards.

You'd feel pretty secure with that much cash, wouldn't you?

Well, that's how Apple shareholders ought to feel right now. They can rest assured Apple will never have a financial problem with that much cash on hand.

Debt isn't always a deal-breaker, though – which brings me to the second type of great balance sheet I look for...

In short, sometimes a company has more debt than cash... But the business is so good that it earns enough to easily cover the debt payments.

Retail giant Wal-Mart (WMT) is the best example of this...

It has $6.5 billion in cash... and $47.6 billion in debt and other long-term financial obligations, more than SEVEN TIMES more debt than cash.

That's a LOT of debt.

But remember, Wal-Mart is a massive company. It does nearly $500 billion in annual sales. It has more than 11,600 locations around the world. It's bringing in tons of cash every second of every day of the year.

The fact is, after Wal-Mart pays all its expenses, taxes, and debt payments, it has enough earnings left over to equal eight times its debt payments.

How good is this?

Well, suppose you have $2,000 per month in debt payments.

Then suppose that after paying all those debt payments, plus all your other living expenses – income taxes, everything – you still have five and a half times $2,000 left over.

So you'd basically have $11,000 a month left over after you paid all your expenses. That means you'd have an extra $132,000 per year you could spend any way you wanted.

You'd be pretty secure financially. And that's how Wal-Mart shareholders should feel.

So why do I care about this so much?

Well, in Extreme Value, we've closed out gains of 113% on tobacco giant Philip Morris International (PM)... 133% on chipmaker Intel (INTC)... 150% on beer titan Anheuser-Busch InBev (BUD)... 125% on Warren Buffett's Berkshire Hathaway (BRK-B)... and more than a dozen other double- and triple-digit gains.

And every single one of those companies had a great balance sheet. I've lost count of how many e-mails I've received from Extreme Value readers who tell me they sleep better at night, knowing each business we find is so financially strong.

So to sum up this financial clue:

  • Look for companies with great balance sheets.
  • Some companies have a lot more cash than debt. That's a great balance sheet.
  • Other companies have more debt than cash, but because they earn so much money, their debt payments are easily covered. This, too, makes for a great balance sheet.

There's another important clue I look for in a great business. Basic economics teaches us this shouldn't happen. But when it does, it's an important clue that a business has a unique advantage. And I've used this clue to find some of the highest-returning investments of my career.

Let me explain...

A company's "profit margin" is simply the amount of profit expressed as a percentage of sales.

For example, if you sell $100 worth of widgets, and your profit is $10 after paying all expenses and taxes, you have a 10% net profit margin.

When I'm looking for a great investment, I look for companies whose profit margins are very, very consistent over a period of several years in a row.

The reason I look for a consistent profit margin is because it's economically unusual. It's an anomaly.

The laws of economics tell us that profit margins shrink over time. For example, suppose a new business is very successful and it's earning a large 20% net profit margin.

That big profit will attract entrepreneurs into the same business. How will those newcomers compete? Easy. They'll accept a lower profit margin for the exact same business... 18%, for instance, instead of 20%.

Over time, this sort of competition can squeeze the profit margins for an entire industry down to almost nothing.

So when you see a business that maintains a fairly consistent profit margin over a long period of time, you should look into the business and see what it's doing to create so much value, so consistently, for its customers.

For example, in Extreme Value, we made 71% in just six months on IMS Health, a medical-information company, which had a consistent profit margin when we found it.

And we logged a 201% gain on Alexander & Baldwin (ALEX), a real estate development company that also had a consistent profit margin.

The consistency of the profit margin is more important than the size of it.

Take Costco Wholesale (COST), for instance.

The big warehouse retail store earns a consistent gross profit of around 12% and a consistent net profit of around 1%. Those are razor-thin profit margins, but they're very consistent, every year, year after year, like clockwork.

That's just one clue that tells you Costco is a really wonderful business.

Wal-Mart is like that, too. It has a 25% gross profit margin and a 3% net profit margin every year, year after year.

A consistent profit margin tells you a business is doing something that its customers value year after year. In the case of Wal-Mart and Costco, for instance, both excel at reducing the cost of essential everyday goods.

If possible, I look for a profit margin that's not only consistent – but thick, as well. That usually means the business is selling a high-value product that costs little to make.

A great example is Apple. Its products cost little to make.

Apple is essentially a luxury-goods company whose products are designed to integrate perfectly into your life... to the point where you can't get through the day without them. That's why Apple consistently has had net profit margins in excess of 20% since 2010... and why it's one of the best businesses on the planet.

There's one thing you should watch out for... Profits and profit margins tend to fall during recessions. But don't let that scare you away from great businesses.

The fact is, investing in great businesses during recessions can be hugely rewarding.

For example, in Extreme Value, we logged a 104% gain on Portfolio Recovery Associates (PRAA), and we're up more than 300% on payroll firm Automatic Data Processing (ADP) – both of which we discovered in October 2008, at the height of the credit crisis.

That's why one Extreme Value reader once told me he no longer has any fear of ups and downs in the market.

So to sum up:

  • Look for a consistent profit margin.
  • Basic economics says that profit margins shrink over time. So a consistent profit margin means the business creates plenty of value for its customers year after year, which is what will drive up the value of your shares.
  • Profit margins can fall during a recession – but will always recover for great businesses.

Finally, I'm going to share what I think is the most important clue when you're analyzing a business.

You see, investment analysis is often a very complicated process, which you can't boil down to a single number. But I've found the next best thing. And it's the final clue I look for in a great investment.

I'm talking about return on equity.

What do I mean by that? Well – if owning a stock were like owning a bank account, then return on equity would be the interest rate you earn.

There are two parts to this: the equity and the return.

Equity is net worth. It's the value the owner of an asset or a business sees after all the obligations are met.

For example, say you own a $600,000 house, and you have a $400,000 mortgage on it. Your equity is $200,000. That's what the house is worth to you, the owner, after you meet all the obligations on it.

It's the same with a business in the stock market. A business has obligations to suppliers, employees, taxing authorities, utility companies... and many others.

To calculate your equity in the business, you add up what all the assets are worth and then subtract all those obligations from that total... just like in the example of a house.

Whatever is left over is called net worth, or equity.

You can find equity – called "shareholder equity" – on the latest balance sheet of any publicly traded company.

So that's the "equity" part of "return on equity."

The return part is the earnings of the business – called "net income" on the income statement of publicly traded companies.

For example, Wal-Mart's latest balance sheet says its shareholder equity is roughly $79 billion. That's what you get when you subtract the value of all Wal-Mart's financial obligations (its liabilities) from the value of its assets.

Over the last four quarters, Wal-Mart's net income was $12.7 billion. So $12.7 billion of net income, divided by $79 billion of shareholder equity, equals a 16% return on equity.

Imagine having a bank account that pays you 16% interest!

A high return on equity signals a great business – not just because it means you're making more money, but because of how it affects the second clue I showed you: rewarding shareholders.

Consider Wal-Mart again...

It makes too much money to plow it all back into its business.

That's why it pays out lots of cash in dividends and share buybacks – which is what helps you, the shareholder, get rich over time.

Here's just a handful of some of the investments I've found in Extreme Value. Each of these businesses had a large return on equity when I found them... like AB InBev, which we closed out for a 150% win... Philip Morris, a 113% winner for us... and Constellation Brands (STZ), which we closed for a huge 631% gain.

Bottom line: Return on equity is a critical number for equity investors. And it's an important clue to finding great investments that help you sleep at night.

Good investing,

Dan Ferris

Editor's note: Dan has recommended three of the Top 10 best-performing stocks in Stansberry Research history... And today, he believes he has found his next big winner. It's a "World Dominating" business that meets all five of his financial clues and trades at a great price.

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