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:

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?

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:

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.