Searching for Bulldog Stocks

By Phil Dow with
Paul B. Brown, authors
The Citizen Investor

       Everyone's heard, "buy good companies and hold them." But a lot of people wonder if there is a way to shortcut the process? The holding on part is relatively easy. Once you find a good firm, as long as it delivers operating performance, you don't sell.
       But what about finding these firms in the first place? Can that be done quickly? If there is a shortcut, it stems from a lot of work. As a Citizen Investor, you need to learn how to find dominant companies, the "bulldogs" as I refer to. Once you know what to look for, spotting them is relatively easy, but getting to that point can take a while.
       But it's worth the commitment. In fact, there's a huge vested interest on my part, and on my firm's part, to deal with informed individuals. I think one of the greatest things we can do is to teach a person, via firsthand experience, what successful investing is all about.
       A bulldog like Medtronic which has performed historically is a wonderful example.
       Medtronic is a company that, as we have seen has been delivering an average of 20% earnings growth over the last two decades or so. Up until the last two years, the stock has been a real winner, and history has shown that pullbacks have been temporary. How does a Citizen Investor find companies like Medtronic?
       Well, first you decide you are going to go looking for them. This is no small point. You need to be committed to all the things we have talked about before:

A disciplined approach to investing. You have developed a strategy that involves owning dominant, winning companies and you are going to stay with it, regardless of what is going on in the overall markets at any given time.
The willingness to be patient. You are going to stick with the strategy for as long as it takes. You've seen what a patient approach has done for a great investor like Warren Buffett.
The resolve to think like an owner. Your focus is on the long-term operating performance of the business you are investing in and not the day-to-day movement of the stock price.

       OK, you have decided to follow my Citizen Investor strategy and you want to find bulldogs for part of your portfolio. Where do you find them?
       Well, it turns out that there are criteria you can use to screen for them. Bulldogs - no matter where they are found - have some things in common.
       Let me give you the ten factors I look for, the things that serve as my checklist before I invest in a company that I hope turns out to be a bulldog.

       Here's a list of characteristics of companies that have historically fit the bulldog criteria, along with some examples of classic bulldogs who have, in prior times, exemplified each of the traits. I'm not presenting it as a shopping list for you, only as a look back at what has worked in the past. Remember, a stock that has historically performed like a bulldog has to continually prove its case to the market and its customers - a bulldog isn't a bulldog forever. After reading the list below, it will be clear what to look for.
       1. They sell a high-quality product or service. I can't think of a bulldog that offers customers even a mediocre product, or provides a service that you would describe as simply adequate. Bulldogs provide customers with, if not the best, then close to the best, product or service in the category they serve. I think of 3M whose culture has historically encouraged and rewarded innovation. Whether it's Post-It Notes, abrasives, coating, or medical products, the company has emphasized quality, and, for this discipline, it has won the Malcolm Baldridge National Quality Award.
       2. They have a leadership position in the marketplace. One reason they have earned it is because of the culture within the company. Organizations that are bulldogs strongly believe that their customers deserve exceptional service and superior products. As a rule, these are very customer-driven, customer-focused companies. They work hard to understand what their customers want and, more often than not, they provide it year after year. Microsoft comes to mind immediately. The company established dominant market share in operating system software early on in the game and has continued to leverage that position in order to dominate other software applications.
       3. They have superior management. Obviously, you can tell that by looking at the numbers, but I would suggest that you don't stop there. You want a company where they don't have a lot of people leaving, where turnover is substantially below the industry average. You want a culture of confidence where management is used to competing and winning. Hopefully, you can find firms that have had the same senior management in place for a while and a company where you can see that they spend a lot of time grooming the next generation of managers to replace the ones who are currently running the company. And you definitely want the CEO to have thought a lot about his or her successor.
       In recent years, MBNA Corporation has epitomized this quality. The majority of senior executives have been with the company for over a decade; this management team has fueled earnings per share (EPS) growth at an average annual rate in excess of 20%. And knowing the importance of succession planning, MBNA has had a very effective employee development program.
       4. They are supremely focused. These companies have a very defined business objective. With the best bulldogs, you can tell at a glance that they understand what business they are in and what they are trying to accomplish because they can easily explain that vision to you.
       How can you discover if the company you are thinking of investing in has this kind of clarity? It is easy enough to find out, as we have seen. Read the letter from the chairperson or president in the annual report - it is invariably one of the very first things you see - or look at the way the company communicates with everyone. Winners are focused. Companies that are clear about what they want to do are equally clear about getting their message across. They will say: "These are our objectives and our strategy; here's how we want to employ our capital and assets." And they will also let you know what their profit and sales targets are. Intel has been an example of a company that in the past has taken its annual report seriously, using that publication to reveal candid information about its objectives and business line outlook, and to critically evaluate past business decisions.
       5. You want to look to an ongoing commitment to market dominance. One way to find that is to ask a series of questions:

Does the company have a major commitment to research and development as a means of growing the business?
Are they low-cost producers?
Have they figured out strategies and tactics that could give them a sustainable competitive advantage over established players in the field?
Does it seem that they have a pretty good idea about how they would handle new competitors in their field?

       In short, you are looking to see if they have a plan for saying on top in their market sector through a strategy of leadership and renewal.
       Wal-Mart Stores has been a classic example of a company that has done this well. It built a very efficient distribution system and focused early expansion on small cities and large towns, where established, smaller stores couldn't compete on price and selection. More recently, the company took over the No. 1 spot for American grocers, leveraging higher margins from their traditional household goods business to undercut the prices offered by the traditional grocery chains.
       6. Is there a record of growth and the probability of future growth? You want to investigate a company to see if it has a business model that can replicate itself without a huge leap in faith. In other words, you want to find companies that can continue to predictably do what they say they are going to do and will be able to do it fairy easily. Pharmaceutical companies are probably a great example of an industry that has set a pretty solid standard for growth.
       Is there a kind of benchmark you should shoot for? Yes. I think you want to find corporations that are growing their earnings by at least 5% to 7% a year. The really outstanding companies tend to grow in excess of 10%.
       If I find a company that has done that for a number of years - and that I feel reasonably confident will be able to continue to produce that kind of excellent performance in the years ahead - I am a buyer.
       Look at Pfizer, Inc. From 1998 to 2003, the firm's pharmaceutical development program has been much more effective at producing drugs to offset patent expirations than their competitors. Consequently, it has had a compound annual growth rate for EPS of 15.9% during the last five-year period.
       7. You want financial integrity... and that means a strong balance sheet, a company that is capable of financing its own growth, rather than borrowing. Traditionally you'd look for companies where debt is no more than 30% of total capitalization. Coca Cola, in addition to keeping its customers loyal, has repeatedly achieved high returns on equity without the use of excessive debt. Coca Cola's debt-to-capitalization ratio is a mere 4.7% (based on June, 2002 balance sheet data and the close on Oct. 4, 2002), and its steady cash flows have served historically to sufficiently fund future growth activities.
       What about companies like Enron and WorldCom where all the financial success has ended up in a pink cloud of lawsuits, accusations, and bankruptcy? Unfortunately, it's unlikely that an individual can determine if a company is fraudulent about its numbers. You can take solace in the fact that, with the recently enacted regulations that have come out of the corporate accounting scandals, anyone who does this faces serious jail time and are likely required to return ill-gained profits. Despite the headlines, integrity is still essential to a successful business career in our country.
       8. You want to invest in world-class competitors. Is this company best of breed in the world? And, having said that, as markets move toward globalization, does their product line provide an element of scale that gives them a sustainable competitive advantage worldwide?
       Nokia has fit this criterion in the past. Based on 2001 sales, Nokia was the market share leader for cell phone handsets in Europe, North America, and Asia. The company has tried to innovate its products based on market research, delivering what customers want even though that often differs from country to country.
       9. There is demand for their products in good times and bad. You don't want to invest in feast-or-famine cyclical companies. By definition, there will be periods when a company that prospers in one part of an economic cycle and struggles in another will find it difficult to grow its sales and earnings. You're looking for companies that tend to have solid demand for their goods or services in even weak economies.
       10. They are diversified. No, not in the sense that GE is diversified. GE is the traditional conglomerate that is in everything from financial services (GE Capital) to airplane engines to television. (It owns NBC.)
       But it is diversified in the sense of Johnson & Johnson, which has had the whole line of medical products, from over-the-counter (Band-Aids and baby shampoo) to prescription drugs to medical device. My sense is that the past track record becomes questionable if you have to bet the whole company on one new product that must get FDA approval. What you are looking for is a robust product line that is diversified throughout the category in which the company competes.
       And that's the checklist. These are the major things that I look for in terms of criteria when I think of investing in a company I hope is a bulldog.