How to Spot the Next Ten Bagger

Shmulik is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

In his classic book, "Common Stocks And Uncommon Profits," Philip Fisher describes the attributes of a great investment, one that will return hundreds of percent in gains to its investors.

One of his main principles to look for in a winning stock is how much the prospective company spends on research and development (R&D). He explains that the only way an investor can realistically expect consistent gains over ten or twenty year periods is if he invests in companies with a strong emphasis on R&D. These companies will always try to stay ahead of the game by developing state-of-the-art technology with state-of-the-art tools.

Where it really counts

Spending on R&D is important in all sectors, be it auto manufacturing, entertainment, or consumer staples. But most all of, it's absolutely essential in the pharma and healthcare sectors. That's because a company that doesn't invest sufficiently in R&D simply won't have a pipeline of new medicines five years down the road.

For pharma companies, investing in R&D literally means investing in the company's lab. And that's why it pays to monitor these exceptional companies that invest heavily in R&D. It's equally important to not only look at the absolute dollar numbers of R&D spending, but to also consider them as percentage of sales. This way, you even the playing field for large and small companies alike.

The superior R&D spenders

The diagnostics division of Roche (NASDAQOTH: RHHBY)) is the biggest R&D spender out there. The maker of Herceptin forked out $1.08 billion in 2012, up from $978 million in 2011. This R&D investment equates to 10% of the company's sales. This is a very high figure, both in absolute terms and in relation to other peers.

Roche can invest so much in R&D because it's flush with cash. Cash flow from operating activities in 2012 totaled $16.5 billion, up from $13.8 billion in 2011. That's an impressive 20% in growth in cash flow from operations. Shares are fairly priced at a forward price-to-earnings of 15x and a price-to-sales of 4.5x.

A second prominent R&D spender is Agilent Technologies (NYSE: A). Agilent spent $668 million on R&D in 2012, which represented 9.7% of its total sales. The company designs and manufactures electronic and bio-analytical measurement instruments and equipment for measurement and evaluation. It's the "blue chip" of the measurement devices sector.

Agilent is a cash generating machine. It made $1.2 billion in cash flow from operations in 2012, up from $720 million in 2010. That's a whopping 66% increase in cash flow from operations in only two years. Shares are modestly cheap, trading at a forward price-to-earnings of 14x and price-to-sales of 2.5x.

Becton Dickinson (NYSE: BDX) was the third largest R&D spender in 2012. The maker of needles and medical syringes spent $472 million on R&D in 2012, which represented 6.1% of total sales. Becton has been gradually improving its cash generation over the years. It made $1.7 billion in cash from operations in 2012, up from $1.5 billion in 2010. It's worth noting that shares of Becton are up 36% since the end of 2012, but are still fairly priced at a forward price-to-earnings of 16x and price-to-sales of 2.5x.

Important caveat

R&D spending doesn't have a color. Some companies invest heavily in products which don't have any direct business relationship to the products that are already within the business scope of the company. The investing community coins this term a "diworsification." 

When a successful watch company thinks that it can also manufacture refrigerators, this usually doesn't end very well for the company's shareholders. That's why, it's also important to pay attention where the R&D money is going. 

Looking ahead

To invest in companies that are heavy R&D spenders is to invest in the future. That's because these companies are more than likely to become the leaders of their industry. If you're aiming for consistent long-term profits, rather than one-time gains, you should consider the R&D clause to be your best guiding friend, especially in the pharma sector. 

The best investing approach is to choose great companies and stick with them for the long term. The Motley Fool's free report "3 Stocks That Will Help You Retire Rich" names stocks that could help you build long-term wealth and retire well, along with some winning wealth-building strategies that every investor should be aware of. Click here now to keep reading.

Shmulik Karpf has no position in any stocks mentioned. The Motley Fool recommends Becton Dickinson. Try any of our Foolish newsletter services free for 30 days. 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 Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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