Stock market analysts often refer to particular stocks a best of breed for investing. But while it may seem simple enough to select only the best stocks in the market, a lot of factors go into identifying best-of-breed stocks.
The first step in choosing stock that is the best of breed is understanding exactly what it means. Market analysts and investors typically classify the thousands of publicly traded companies into sectors and industries. Market sectors include technology, energy, financial, health care, real estate and others. For example, Microsoft Corp. (ticker: MSFT) is in the technology sector, while Valero Energy Corp. (VLO) is in the energy sector.
Within each market sector, stocks are further broken down into different industry classes, which group companies according to their similar businesses. Valero and Halliburton Co. (HAL) are both members of the energy sector. Halliburton operates in oil and gas production, while Valero is a member of the oil refining industry.
When it comes to understanding market classifications, the best-of-breed metaphor is fairly helpful. Market sectors are like species of animals. Microsoft (technology) is like a cat and Valero (energy) is like a dog. Valero and Halliburton may both be energy companies (dogs), but their businesses are as different as a golden retriever and a poodle.
Dog show judges compare only participants of a given breed when selecting a best-of-breed winner, and the same is true of market analysts. Within a given industry, analysts can easily make apples-to-apples comparisons among stocks and choose which stock they see as the industry leader.
Each industry has its own set of metrics that is specific to that particular industry. For example, airline analysts often reference PRASM, or passenger revenue per available seat mile. PRASM is a measure of efficiency among airliners, and it plays an important role in identifying the best-of-breed airline stock.
“Finding the best stocks within a certain sector involves both quantitative and qualitative evaluation,” says Owen Murray, director of investments for Horizon Advisors. “An analyst will carefully review the measurable aspects of the business, such as profit margins, revenue growth, financial strength and market share.”
But while winning the battle of numbers is certainly one indication of best-of-breed status, there are other factors in play that can be more difficult to quantify.
“It is also very important to evaluate a company’s intangible qualities, such as reputation, brand recognition and the effectiveness of the management team,” Murray says.
Mike Loewengart, vice president of investment strategy at E-Trade, says best-of-breed companies typically demonstrate some form of competitive market advantage over their peers. “There is no silver bullet in finding top-flight stocks, but many times it boils down to wide economic moats created by competitive positioning and top-line growth,” he says.
“Regardless of the sector, best-in-class stocks are most often cut from the same cloth,” Loewengart says. “They enjoy a dominant market position and command strong balance sheets.”
Investors can perform a quick online search to track down a company’s profit margins in the most recent quarter. However, it may take some digging and some subjective interpretation to identify the best CEO in the oil refining industry.
One shortcut investors can typically use to identify the best-of-breed stock in a given industry is to look for the priciest stock. Investors are well aware that quality, best-of-breed stocks such as Coca-Cola Co. (KO), Wal-Mart Stores (WMT) and McDonald’s Corp. (MCD) have historically made excellent long-term investments. With the expectation of consistent long-term returns, investors are willing to pay a little extra to have these stocks in their portfolio.
TD Ameritrade chief strategist JJ Kinahan says investors will pay a premium for best-of-breed stocks because they are getting the highest level of performance within a given industry.
“Best-in-breed stocks are so consistent and well-performing that they are year in and year out a good measuring stick for the rest of their industry,” Kinahan says. “Best in breed is truly, in my opinion, about a consistency that investors know they can count on.”
That consistency is particularly valuable during a broad market recession or a cyclical downturn within a given industry. When a particular industry goes through an extended downturn, best-of-breed companies are the least likely to fall to bankruptcy, and they have the most insulation from severe financial fallout. Even if a large portion of a particular industry doesn’t survive the downturn, investors can count on the best-of-breed stocks to weather the storm.
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