Forget Utopia. You simply want to invest in companies with an intrinsic value well above their current share price and that have an excellent track record of performance in their particular field of endeavor. At the same time you want to monitor them on a quarterly basis to ensure an ongoing performance that meets your requirements. By doing so, you are likely to chalk up those positive absolute returns.
Exceeding the performance of one or more of the major equity indexes is known as relative performance. Yet, what really counts is absolute performance. In other words, you want a certain minimum repeating annual return over and above your original investment. Outperforming a negative index number with a less of a negative number is not an acceptable result.
You want to train yourself to stay focused on finding companies that are outgunning their competition as they generate better-than-average profit growth. Ultimately, a stock's performance is tied to earnings.
Furthermore, any company you're thinking of investing in must generate sufficient amounts of cash such that after paying its bills each month and meeting other obligations, it creates a surplus of cash.
This is known as "free cash flow," and is considered an indicator of safety because the funds can be used for growth, paying down debt or to cover unexpected contingencies. The best-performing companies generate just under 6 percent of their market capitalization in cash each year.
No methodology would be complete without mentioning dividends. You want to look for firms that have consistently raised their dividend. My suggestion is eight consecutive years of increases. Rising dividends are a sign of a company's financial health and its confidence in being able to generate ever higher earnings going forward.
Ned Davis Research found that over the past 30 years, dividend growers have returned an average of 10.4 percent annually, compared with 9.4 percent gains for basic dividend payers and 1.5 percent for non-payers.
Unfortunately, regardless of how well you hone your skills, not every company you select is going to be a winner. Nonetheless, if you are careful in your selection, your portfolio's absolute return is likely to outperform not only the major indexes but also the vast majority of mutual funds. That conclusion is based on my more than four decades of Wall Street experience.
So by now you are probably saying to yourself that I should provide you with an example to springboard your efforts. One company you might consider is United Technologies. The company has been raising dividends for 19 years. Its intrinsic value using a discounted earnings approach is $112. A more conservative discounted free cash flow to the firm model generates an intrinsic value of $125. The shares recently closed at 95.12.
My earnings estimate for 2013 is $5.95 per share with a projected 12-month share price of $110 for a capital gain of 15 percent. In addition there is an indicated dividend yield of 2.30 percent, for a projected total return of 17.3 percent.
Lauren Rudd is a financial writer and columnist. You can write to him at LVERudd@aol.com.