Monday, 29 March 2010

The Dark Secret of the Best-Performing Stocks

By Matt Koppenheffer 

At this point, I've seen this list of the past decade's top-performing stocks so many times that I can recite most of them from memory. But there's good reason to keep picking apart these top performers, because any one of them had the potential to turn a mediocre portfolio into a market-beater.
Here's a peek at 10 of the top 25 performing stocks of the past decade:
Price Change Jan. 1, 2000,
to Jan. 1, 2010
Bally Technologies
XTO Energy (NYSE: XTO)
Southwestern Energy
Clean Harbors
Deckers Outdoor
Jos. A Bank Clothiers
Range Resources
FTI Consulting
Terra Industries (NYSE: TRA)
Source: Capital IQ, a Standard & Poor's company.
The list may look pretty familiar, but what you may not know is that these companies, and many of the decade's other top performers, share a dark secret.
Skeletons in the closet
If you're thinking I'm going to say that all of the companies above were small and that they beat the pants off of large, well-known stocks like Procter & Gamble (NYSE: PG) and Disney(NYSE: DIS) (which returned 10.7% and 10.3%, respectively), I'm not. It's true, but a number of my colleagues have already done a great job highlighting that very important aspect.
So what is the secret, then? Instead of simply telling you, let's take another look at the companies listed above and see if you can figure it out.
Price Change Jan. 1, 1998, to Jan. 1, 2000
Return on Equity in 1999
Debt-to-Equity in Early 2000
Bally Technologies
Negative book value 
XTO Energy
Southwestern Energy
Clean Harbors
Deckers Outdoor
JoS. A. Bank Clothiers
Range Resources
FTI Consulting
Terra Industries
Source: Capital IQ, a Standard & Poor's company.
Now what would you say ties all of these top-performing companies together?
If you said something to the tune of "they looked like terrible investments," then you get a gold star. Even a quick glance at that chart would send chills up the spine of most fundamental-oriented investors. Many of the companies were unprofitable, the ones that weren't produced lackluster returns on capital, and quite a few were swimming in debt.
Maybe it's not so surprising, then, that the market hated these stocks at the time. Those are some massive declines posted above, and bear in mind that this was over a period when the S&P jumped more than 50%.
Time to scrap everything we know?
Does this mean that we should forget about looking for high-quality companies trading at reasonable prices in favor of looking in the garbage bin? I don't think so.
The list of the decade's top-performing stocks isn't the only place where lousy returns on equity and high debt levels show up. You can also find numbers that look like that on a list of the decade's bankruptcies.
According to Capital IQ, there were 667 publicly traded companies with market caps above $10 million that filed for bankruptcy over the past decade. In 2000, only 22 of those companies could claim a return on equity above 15% and debt-to-equity below 50%. The rest of the companies that went belly up sported numbers that looked a lot like those in the chart above.
In other words, taking fliers on companies with ugly-looking financials could land you a massive winner, but it also gives you a big chance of taking hefty losses.
Swing at good pitches
By sticking to investing in reasonably capitalized and solidly profitable companies that are trading at attractive prices, we may miss out on some of the biggest winners, but we also vastly reduce the chances of sticking ourselves with clunkers headed toward bankruptcy.
And don't worry, there are still plenty of opportunities for big returns. With gains of 9,211% and 7,024%, respectively, Green Mountain Coffee Roasters (Nasdaq: GMCR) andHansen Natural (Nasdaq: HANS) were two of the very best performing stocks of the decade, and both would have fit a "high quality at a reasonable price" strategy back in 2000.
Of course, even companies that produce good-looking numbers can end up being poor investments. Ten years ago, the numbers all seemed to line up for American Capital(Nasdaq: ACAS) and Ethan Allen Interiors, but both stocks ended up getting clobbered.
That's why the team at the Motley Fool Hidden Gems newsletter not only focuses on companies that produce attractive financial returns, but also digs in to evaluate intangibles like competitive moat, growth opportunities, and management effectiveness. The team's research recently led it to buy shares of a fashion retailer for the newsletter's real-money portfolio.

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