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2 Out Of 3 'aint Bad

|Includes: EBAY, The Coca-Cola Company (KO), MCD

A recent article on Motley Fool stated that eBay, Coca-Cola and McDonald's are "perfect" stocks. They state that a perfect stock is one that is predictable, profitable, and cheap, and that it is hard to lose money if you only buy stocks that meet all three criteria. Three stocks mentioned above currently meet those criteria, according to The Fool.

We agree... on two of the three.

Coca-Cola and McDonald's are superstar stocks.

eBay is not.

Here's why:

As the Fool points out, one key to making a "perfect" stock is predictability. McDonald's and Coca-Cola are predictable. McDonald's serves fast food, and Coca-Cola sells carbonated soft drinks. While company has unrelated operations from time to time, the core of each company's operations remains the same.

"Another part of predictability is the tendency to earn the same level of profit per item sold each year. A company that generates a consistent profit margin each year is likely insulated from competition and has control over its prices. Over the last ten years, eBay, McDonald's, and Coca-Cola generated remarkably consistent free cash flow margins; none fluctuated more than 20% from the mean in most years -- extremely low rates of fluctuation," the Fool said.

Another component that makes a stock "perfect" is the ability for competitors to come out of nowhere and take away market share. McDonald's and Coca-Cola are well-established and it is unlikely they will lost their dominant positions anytime in the near future.

eBay, on the contrary, can lose market share overnight to an internet startup that becomes red-hot, or to an established giant like Facebook, who could enter a similar arena. It's been rumored that Facebook will soon introduce a payment system, which will likely severely impact Pay Pal (owned by eBay). Facebook has a huge following and many people are not happy with Pay Pal. Look for a big swing in customer loyalty the day Facebook launches their payment system.

Moreover, eBay is not being honest with their investors. As the Fool mentioned (in a different article), "Over the past 12 quarters, going back to Q3 2010, eBay has bought back $3.6 billion worth of stock. The stock has approximately doubled over that time frame, so you might be thinking that was a great use of capital. Unfortunately, the diluted share count only decreased by 1% over those 12 quarters. The count went from 1.328 billion shares to 1.313 billion at the end of the recent quarter.

How can a company buy back $3.6 billion of stock and only reduce its share count by 15 million shares? That would imply a cost of $241 per share on average. We know the stock price was in the range of roughly $25 to $50 per share during that time.

The answer is that eBay issues a lot of stock to its employees. During the second quarter, their reported free cash flow was $658 million and they used 70% ($466 million) of it to repurchase shares. In Note 15 of their annual report, management clearly discloses the goal of their share repurchase program: 'These stock repurchase programs are intended to offset the impact of dilution from our equity compensation programs.'"

Back to the two winners:

McDonald's operates in an industry where it uses its enormous scale to extract concessions from suppliers, attract the best franchisees, and appeal to a worldwide consumer base. As a pioneer in the quick-serve restaurant industry, McDonald's continues to benefit from its first-mover advantage, and only a mass consumer migration away from fast food can impede its earning power.

Like McDonald's, Coca-Cola earns predictable profits due to its unmatched scale. It has a distribution network that no other competitor can replicate and a brand that consumers worldwide can identify. As with McDonald's, Coca-Cola's competitive advantages are too great for a rival carbonated-beverage company to overcome; the only plausible cause of declining profitability is a mass consumer migration away from carbonated soft drinks.

Finally, there is the Warren Buffett factor: He is the single largest shareholder in Coca-Cola. He knows what he's doing. If we all followed his advice, we'd also be billionaires.

Moreover, Coke Coca-Cola is an exportable brand. It is something that all people in all countries can enjoy and the company has a massive distribution network that can deliver the product to all parts of the world. Average consumption worldwide is one-fourth the rate of that in the top 10 markets for Coca-Cola. On paper, that's a vast untapped market.

So drink up and eat up. McDonald's and Coca-Cola. Two great... no, make that "perfect" stocks!