5 Traits of Great Stocks

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.

If you'd like to know the other key traits we demand in Motley Fool Pro, and see what we're buying now, you have a chance to take a look for a few days in June. To keep membership manageable, Motley Fool Pro won't be reopening again until at least 2010. So, come on in while you can, and see what the fuss is all about.