Every investor would love to stumble upon the perfect stock. But will you ever really find a stock that provides everything you could possibly want?
One thing's for sure: You'll never discover truly great investments unless you actively look for them. Let's discuss the ideal qualities of a perfect stock, then decide if Cree (NAS: CREE) fits the bill.
The quest for perfection
Stocks that look great based on one factor may prove horrible elsewhere, making due diligence a crucial part of your investing research. The best stocks excel in many different areas, including these important factors:
- Growth. Expanding businesses show healthy revenue growth. While past growth is no guarantee that revenue will keep rising, it's certainly a better sign than a stagnant top line.
- Margins. Higher sales mean nothing if a company can't produce profits from them. Strong margins ensure that company can turn revenue into profit.
- Balance sheet. At debt-laden companies, banks and bondholders compete with shareholders for management's attention. Companies with strong balance sheets don't have to worry about the distraction of debt.
- Money-making opportunities. Return on equity helps measure how well a company is finding opportunities to turn its resources into profitable business endeavors.
- Valuation. You can't afford to pay too much for even the best companies. By using normalized figures, you can see how a stock's simple earnings multiple fits into a longer-term context.
- Dividends. For tangible proof of profits, a check to shareholders every three months can't be beat. Companies with solid dividends and strong commitments to increasing payouts treat shareholders well.
With those factors in mind, let's take a closer look at Cree.
What We Want to See
Pass or Fail?
|Growth||5-Year Annual Revenue Growth > 15%||20.5%||Pass|
|1-Year Revenue Growth > 12%||1.1%||Fail|
|Margins||Gross Margin > 35%||37.6%||Pass|
|Net Margin > 15%||6.1%||Fail|
|Balance Sheet||Debt to Equity < 50%||0%||Pass|
|Current Ratio > 1.3||7.40||Pass|
|Opportunities||Return on Equity > 15%||2.7%||Fail|
|Valuation||Normalized P/E < 20||67.44||Fail|
|Dividends||Current Yield > 2%||0%||Fail|
|5-Year Dividend Growth > 10%||0%||Fail|
|Total Score||4 out of 10|
Source: S&P Capital IQ. Total score = number of passes.
Since we looked at Cree last year, the stock has dropped by two points. With revenue growth slowing and margins stumbling, the company has seen its earnings multiple rise despite a big drop in the shares over the past year.
Cree is a leader in light-emitting diode technology. After the largely failed adoption of compact fluorescent light bulbs with their toxic mercury content, LEDs appear to be the next big technology for lighting. Industrial giants General Electric (NYS: GE) and Philips are looking closely at LED lighting as they try to sustain their positions as lighting leaders, and GE even partnered with Cree to produce LED bulbs. Cirrus Logic (NAS: CRUS) is also making a play in the space as it looks to expand beyond sound-processor chips to make power-management modules for LED lighting systems.
Cree faces competition in a number of LED applications. Universal Display (NAS: PANL) is trying to disrupt the LED television market with its organic LED technology, or OLED, with attendant energy savings and greater flexibility. Moreover, the possibility of China adopting LED lighting has some looking at Veeco Instruments (NAS: VECO) , which makes the equipment used to manufacture LEDs.
In its most recent quarter, Cree missed estimates and gave bad guidance for the coming quarter. The challenge in an industry with falling prices is maintaining profitability, and so far, Cree's margin contraction shows that it's losing the battle -- at least right now.
For Cree to get moving in the right direction again, it needs to differentiate itself in what could easily become a commodity business. If it can fight off OLED technology and stay in front of the pack, then adopting higher-margin products could help it restore its path toward perfection.
No stock is a sure thing, but some stocks are a lot closer to perfect than others. By looking for the perfect stock, you'll go a long way toward improving your investing prowess and learning how to separate out the best investments from the rest.
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At the time this article was published Fool contributor Dan Caplinger doesn't own shares of the companies mentioned in this article. The Motley Fool owns shares of Cirrus Logic. Motley Fool newsletter services have recommended buying shares of Universal Display. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool has a disclosure policy.
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