The Top Stocks and the Top Returns

What is the most quoted yet least significant statistic in investing? How about the trailing-12-month return? While there may be many other candidates, consider the TTM return's strong qualifications:

  1. It's purely backward-looking.
  2. It's too short a time frame to have any statistical significance.
  3. It requires lots of context to have any sort of meaning.

So what am I about to do? Throw a boatload of TTM returns at you. But I think you'll find these interesting.

Allow us a moment of self-promotion
If you haven't yet heard of, surfed, or joined our free Motley Fool CAPS investing platform, I encourage you to do so. The system simply asks you to predict whether the stocks you select will underperform or outperform the S&P 500 over the time period of your choosing. In turn, the system rates each stock and each investor (who's made at least seven picks) -- and then incorporates those ratings to make each subsequent rating smarter.

The plumbing, however, is not as important as the information that CAPS throws off. And now that it's been a year since we opened CAPS to the investing public, we finally have some findings on the quality of its information.

Insert drumroll here
Stocks in CAPS are rated on a scale of one to a maximum five stars. Because CAPS ratings are based entirely on investor sentiment, we wondered at the outset how good its predictive abilities would be.

We have the beginnings of an answer:

Stock Group

TTM Return

Beta

Five-Star

27.9%

1.00

Four-Star

19.3%

0.92

Three-Star

10.7%

0.89

SPDRs (AMEX:SPY)

8.5%

1.00

Two-Star

(1.2%)

0.91

One-Star

(16.6%)

0.96

Source: Internal data from Nov. 6, 2006 to Nov. 5, 2007.

The TTM returns of these groups correlate precisely with their relative quality according to CAPS. Five-star stocks ran far ahead of the market; one-star stocks trailed it substantially. And which top five-star stocks drove the returns above?

Best 5-Star Stocks

TTM Return

CNOOC (NYSE: CEO  )

173%

Mechel Open Joint (NYSE: MTL  )

160%

CVRD (NYSE: RIO  )

157%

ICO (Nasdaq: ICOC  )

155%

Sun Hydraulics (Nasdaq: SNHY  )

148%

A year ago, the CAPS community -- now tens of thousands strong -- correctly foresaw continued strength in China, a steady commodities boom, and a number of tiny companies, including ICO and Sun, that were poised to be big winners.

But there's a more interesting slice of stocks
However, one tiny slice of CAPS looks even more profitable than the five-star universe:

Stock

TTM Return

Aluminum Corp. of China

311%

Intuitive Surgical (Nasdaq: ISRG  )

238%

Southern Copper

168%

Excel Maritime Carriers

168%

Yingli Green Energy

165%

What do these names have in common? It's not China, or commodities, or hypergrowth. Instead, these are the returns from newly minted four-star stocks.

The deal with four-star stocks
Looking back over the entire 15 months since CAPS first launched as a public beta, we've found that stocks that transition from three to four stars seem to have considerable upside potential. Now, this seems counterintuitive, but we've developed a theory.

CAPS weights investor sentiment. So while five-star stocks have clear bullish consensus, stocks transitioning from three to four stars are likely driven by the "smart money." By getting in early -- before the crowds -- these folks are able to eke out a few extra percentage points of gain.

To wit, our researchers found that a portfolio of stocks purchased as they became four-star stocks, and sold when they became 4.5-star stocks, returned 41% -- the best returns any CAPS segment had to offer.

Of course, it's only been a little more than a year
The data history is short, and it can't be backtested. But it's interesting, intriguing, and potentially very profitable. And there's something about those four-star transition stocks (catchy name, right?) that makes sense.

If you'd like to look at today's five-star stocks, or some potential four-star transitioners, join our free CAPS service today. Although the CAPS data may look different next year, it will be that much smarter so long as the community expands.


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Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On July 01, 2008, at 11:57 PM, NevadaBuilder wrote:

    OK - I get how we can see when a 3 star becomes a 4 star, but how can we know when it becomes a 4 1/2 star?

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