No secret to investment success … except this one

Last week, I shared a private conversation I had with a wealthy friend of mine.

My friend is the CEO of a major global business. Several years ago, he asked me to help him with his personal portfolio.

"There's no secret to investment success," I told him. "As the leader of a big global business, you've done dozens of very successful acquisitions. You know exactly what creates business success. And you know the appropriate price to pay for private companies. Just apply the exact same care to your personal investment decisions."

Today, I'd like to share the numbers that prove just how important business judgment can be to investors. I'll also show you where to find the world's greatest businesses today.

Assume that you had perfect business judgment 20 years ago. You could tell, just looking at various public companies, which ones had "the right stuff." You decided to invest $100 each in 10 stocks. You picked your 10 investments by figuring out which companies would increase their per-share book value the most over the next 20 years.

Knowing the companies would thrive, you assumed stock prices would eventually follow.

If you'd done that, your $1,000 portfolio of 10 stocks would now be worth $74,283.60. That's an annualized return of a little more than 24 percent – about three times better than the market in general over that time.

Obviously, no one can possibly predict which 10 S&P 500 companies will produce the highest per-share book value gains over 20 years. But ...

Gauging the qualities that make for a successful business is vastly easier and far more certain than trying to predict future investment performance any other way.

Interestingly, my hypothetical 24 percent a year, which assumed perfect knowledge, isn't that much different than Warren Buffett's actual record at his holding company, Berkshire Hathaway, where he has averaged about 19 percent a year over the length of his career.

His approach is based entirely on business judgment and paying a fair price.

Likewise, I believe my biggest advantage as a stock-picker is simply that I've owned and operated a successful publishing company for almost 15 years. I know from my own experiences in business the factors that really matter and allow a business to grow. I look for these same factors in the stocks I recommend.

But what if you've never owned a business? What if you've never been a part of a senior management team? Is there any other way to begin to acquire some of the same insights into how businesses really work and the factors that tend to matter the most over the long term?

If I wanted to learn a lot about how businesses work best, I'd study the businesses that have been most successful in the past. I'd think about what allowed them to increase their value so rapidly over a long period. I'd try to figure out which companies today have those same qualities.

Looking at today's S&P 500, the companies that increased their per-share book values the most over the past 20 years (1992-2012) were:

Chesapeake Energy
Express Scripts
Kohl's
Qualcomm
Intuit
Cisco Systems
Bed Bath & Beyond
Oracle
Urban Outfitters
EMC Corp.

You can break down these companies into one of three large baskets of superior performance.

The first category is technological innovation. Qualcomm, Intuit, Cisco, Oracle and EMC all participated in the dominant technological trend of the past two decades – the Internet. By creating the proprietary software, hardware and wireless-networking technology that created the Internet and just about every other Internet-based business, these companies were able to achieve extraordinary profit margins and huge returns on equity.

This trend, by the way, continues today. More powerful extensions of the Internet are constantly being created, like "cloud"-based services, massively multiplayer online games, social networks, payment systems and communication tools, like Skype.

Can you find any leading businesses in these sectors, whose innovations have created huge operating margins and whose shares are trading at a fair price? Hint: We recently recommended one in my newsletter. It's currently trading at less than 10 times cash flow. It has an operating margin in excess of 35 percent, and it's earning more than $1 billion a year on tangible equity of less than $2.5 billion. This is a great business, trading at a fair price. (Note: We currently rate the shares a "hold" simply because of our concerns about the overall market, but we're probably being too cautious.)

I'd call the second obvious category merchandizing:Express Scripts, Kohl's, Bed Bath & Beyond, and Urban Outfitters. Buffett owns a lot of retail stores for a reason. These are great businesses – if they have merchandise people love.

Kohl's' formula has been to get exclusive rights to certain merchandise – like Vera Wang (according to my wife) – which helps protect it from competition. That's what creates a double-digit operating margin and 15 percent annual return on equity. Even minor amounts of growth from new stores will create a lot of wealth.

I have to admit that the results at the other big retailers on my list are simply a mystery to me. I don't know how they do it. I was shocked to see a nearly 20 percent return on equity at Urban Outfitters and a 26 percent return on equity at Bed Bath & Beyond.

These companies have figured out how to merchandize expertly, then paired that skill with great financial management – especially at Bed Bath & Beyond. This company's results are simply amazing. It has no debt and continues to buy back mountains of stock (about $2 billion in the last three years). Today, you can buy the stock for only 12 times earnings.

Finally, there's Chesapeake Energy. I'd call the secret to that company's long-term success simply "discovery." It found tremendous amounts of natural gas in the United States over the last 20 years by looking in places (shale formations) that everyone else thought would never produce.

Plenty of companies are doing the same right now with oil all over Texas' Permian Basin, where the oil shale is much thicker than in other regions, like the Bakken in the Northern Plains or Texas' Eagle Ford. Look for companies like Laredo Petroleum (LPI), Devon Energy (DVN) and Concho Resources (CXO) to produce similar long-term results because of massive new discoveries.

I hope you've learned more about what makes for a great business over the long term. Work on learning more about these kinds of businesses – innovation, retail and discovery – to continue to grow as an investor.

P.S. Despite my general concerns that we face a severe market correction in the near future, I continue to believe that holding the stocks of a few elite businesses is critical to weathering the turbulent economy I predict. And in my Investment Advisory, we keep a portfolio of stocks in what I call "the world's best business." To learn more about my advisory and how to access all my research on these stocks, click here.