The Perfect Company
By Chandler Lutz
December 19, 2007
By the title of this article you may be thinking that I’m going to tell you what the perfect company is and why. Well, let me just get the disappointment out of the way: I’m not going to tell you what it is. However, in this section we will try to make your search of the perfect company clearer by developing the attributes of the quintessential firm.
Before we jump right in, let me digress. Often times when people in our society purchase things such as houses, televisions, cars or appliances they often have in mind exactly what they are looking for. Let’s look at the example of houses. When people are in the market for a new home they have in mind a “dream house.” For some people a dream house may have a walk out basement and a large kitchen in a nice suburb while other people prefer wood floors and a luxurious master bedroom in a busy city. Once a potential buyer develops the idea of their dream house, they go around check all the houses available and see how they match up to their idyllic home. They may never find the perfect house, but they certainly can come close. Also, the more exact definition of a dream house the buyer possesses, the easier it will for him to search for it. If you know that your dream house must contain wood floors and double pane windows then any house without both of those characters can easily be dismissed. This strategy will allow the buyer to ensure he maximizes his search time and his eventual rewards.
This idea seems quite logical when applied to houses, so why can it not be applied to stocks? If an investor has the perfect company in mind his search and analysis will become much simpler. He will waste less time studying companies that do not meet his investment criteria. The next obvious question is what is the perfect company? Just like the definition of the perfect house varies from homeowner to homeowner, the perfect company varies from investor to investor. Some people may prefer companies that pay dividends while others may not and some may prefer companies in a particular industry to exploit a professional edge while others may wish to avoid that sector altogether. Clearly, there are as many ways to define the ideal company as there are overpriced stock brokers in New York City. So, to guide you on your way to finding your perfect company we will look at what some of the great all-time investors have defined as their model firm.
First, let’s begin with Peter Lynch. In the book One Up On Wall Street the legendary fund manager laid out the principals of his dream firm:
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It Sounds Dull—or, Even Better Ridiculous
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It Does Something Dull
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It Does Something Disagreeable
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It’s a Spinoff
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The Institutions Don’t Own It and the Analysts Don’t Follow It
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There’s Something Depressing about It
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It’s in a No-Growth Industry
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It’s got a Niche
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People Have to Keep Buying It
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It’s a User of Technology
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The Insiders are Buyers
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The Company is Buying Back Shares
These criterions may differ from those of many other financial professionals. Number (10), the company is a user of technology implies that Lynch’s prototypical firm is not a tech firm (and he later says so in the book). This would eliminate Cisco, Microsoft, Intel and many other companies from his list of potential stocks. However, many people may find that these companies are wonderful investments. Also, Peter Lynch mentions nothing about the quality of the firm’s management whereas many people in the financial place a value of who’s running the firm.
Philip A. Fischer takes a quite different approach. He focused largely on manufacturing companies and other technology stocks as well as the quality of management. He outlined 15 points to look for in a common stock:
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Does the company have products or services with sufficient market potential to make possible a sizeable increase in sales for at least several years?
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Does the management have a determination to continue to develop products or processes that will still further increase total sales potentials when the growth potentials of currently attractive product lines have largely been exploited?
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How effective are the company's research and development efforts in relation to its size?
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Does the company have an above-average sales organization?
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Does the company have a worthwhile profit margin?
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What is the company doing to maintain or improve profit margins?
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Does the company have outstanding labor and personnel relations?
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Does the company have outstanding executive relations?
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Does the company have depth to its management?
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How good are the company's cost analysis and accounting controls?
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Are there other aspects of the business, somewhat peculiar to the industry involved, which will give the investor important clues as to how outstanding the company will be in relation to its competition?
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Does the company have a short-range or long-range outlook in regard to profits?
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In the foreseeable future, will the growth of the company require sufficient equity financing so that the larger number of shares then outstanding will largely cancel the existing stockholders' benefit from this anticipated growth?
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Does the management talk freely to investors about its affairs when things are going well but "clam up" when troubles or disappointments occur?
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Does the company have a management of unquestionable integrity?
Fisher’s 15 points differ greatly from Lynch’s concepts and include much discussion about the quality of management.
Warren Buffet has also stated the characteristics of his ideal investment. These include
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A simple and easy to understand business
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Honest and competent management
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A durable competitive advantage
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No technology.
As you may have noticed, many of these investment ideas overlap. Both Buffet and Fisher are looking for managers with great integrity and Buffett and Lynch desire firms with a niche or some advantageous competitive framework. Before you can start searching for a great company, you must know what a great company will look like. Your exemplary firm may be similar to that of Buffet, Lynch, Fisher, some combination thereof or include features pertaining to your personality.
Before I sign off, I want to disclose a disclaimer: even if you have found a great company that meets all your investment criteria, that does not make the company a solid investment. In all the above analysis there is no mention of the company’s valuation. A great company with an overvalued price tag does not make for a great stock. Once you have found your perfect company (or something close to it), you have only found an investment if there is an attractive valuation to go along with it.