The Right Place to Find Winning Stocks

When you're searching for winning investments, it's natural to look to the companies that have already beaten their competitors to sit at the top of their industries. But surprisingly, those stocks often don't do as well as their smaller competitors. To find the best chance of success, you have to dig deeper to find the companies with the potential to become the next industry leaders.

Presenting the evidence
Rob Arnott, who heads the stock research firm Research Affiliates, is perhaps best known for pointing out that investing in bonds 40 years ago would have paid better returns than investing in stocks. But earlier this year, Arnott took an interesting look at how stocks of industry-leading companies perform over time.

What Arnott found was that from 1952 to 2009, stocks of industry leaders underperformed their overall industries by more than three percentage points for as long as 10 years after taking the reins at the top. Moreover, this relationship held true for nearly every sector of the market. Only energy stocks managed to avoid the phenomenon, as ExxonMobil has stayed at the top throughout the 57-year period of Arnott's research.

Investing in industry leaders seems safe, because unlike an industry's small players, there's little chance of big companies going completely out of business. But to maximize your returns, you should take a closer look beyond the bigwigs. Let's take a look at three examples of stocks that could beat the returns of their industry's top dogs.

1. Hansen Natural (Nasdaq: HANS  )
The beverage industry has long been dominated by Coca-Cola (NYSE: KO  ) and PepsiCo (NYSE: PEP  ) . But ever since Hansen Natural burst onto the scene 15 years ago, it has put up phenomenal stock performance, with average annual returns of nearly 50%.

In part, Hansen's success comes from having redefined its market. Rather than meeting Coke and Pepsi head-on, Hansen has increasingly focused on its Monster energy drink sales to drive its growth. Yet even as a much bigger player than it was in years past, the beverage maker has still maintained strong net margins and returns on equity. With a market cap of just $4 billion, Hansen has plenty of room left to grow.

2. Metropolitan Health Networks (NYSE: MDF  )
Health-care plan providers haven't been great investments lately, as recent government reform and weak industry conditions have hurt profits. Although industry leader UnitedHealth Group (NYSE: UNH  ) has seen revenue and income growth return after a choppy couple of years, the numbers remain a shadow of how they looked five years ago.

Tiny Metropolitan Health, however, has stayed on the upswing. The Florida-based provider service network operator has seen its stock rise 80% since last year, as the company recovered from a tough period in 2005 and 2006 to post 40% annual growth in net income in each of the past two years.

As a small player, Metropolitan Health has two ways to win for investors. Continuing its upward swing should continue to carry shares higher. Alternatively, consolidation in the health-care industry could make Metropolitan an attractive buyout candidate. Either way, finding a good niche may end up being a far better way to play the sector than hoping that UnitedHealth can work its way through an increasingly difficult regulatory environment.

3. Hudson City Bancorp (Nasdaq: HCBK  )
It's no secret that big banks suffered the most during the financial crisis. JPMorgan Chase (NYSE: JPM  ) , the largest of the money center banks by market cap, took $17 billion in asset writedowns during 2008. It had to cut its dividend by more than 85%, and its shares are still down 25% from where they peaked in 2007. Other big banks have done even worse.

But beyond Wall Street, New Jersey-based savings and loan Hudson City has stayed a lot healthier. It has seen steady growth throughout the crisis and has consistently increased its dividends even while its larger competitors were slashing theirs.

Shares have suffered along with the rest of the banking sector, as Hudson City has seen more nonperforming loans in the past year. But if the company raises its loan-loss provisions and shareholders panic, the ensuing share price drop might prove a good opportunity to buy shares of a long-term winner even more cheaply than you could now.

Look beyond the obvious
Sticking with tried and true industry leaders is a solid, conservative way to invest. But if you're looking for big winners, look past those leaders to cull out some of their best up-and-coming competitors. It's there that you'll find your best chance at huge outperformance.

If you're looking for winning stocks, we've got some ideas for you. Click here to get the Motley Fool's free report, 5 Stocks the Motley Fool Owns ... And You Should Too.

True to its name, The Motley Fool is made up of a motley assortment of writers and analysts, each with a unique perspective; sometimes we agree, sometimes we disagree, but we all believe in the power of learning from each other through our Foolish community.

Fool contributor Dan Caplinger has never settled for the obvious. He doesn't own shares of the companies mentioned in this article. Hansen Natural is a Motley Fool Rule Breakers recommendation. UnitedHealth Group is a Motley Fool Stock Advisor choice. Coca-Cola and PepsiCo are Motley Fool Income Investor recommendations. Motley Fool Options has recommended diagonal call positions on PepsiCo and UnitedHealth Group. The Fool owns shares of Coca-Cola and UnitedHealth Group, which are both Motley Fool Inside Value picks. Try any of our Foolish newsletter services free for 30 days. The Fool has a disclosure policy.


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