A Simple Secret to Market-Beating Returns

For the past three years, one piece of underappreciated scuttlebutt has helped investors in the know clobber the market by over 6 percentage points per year. In the long run, that outperformance could make the difference between working through retirement and retiring early with true wealth.

I'll get to what the piece of scuttlebutt is in one minute, but first, I want to examine what it's predicated on: culture and leadership. Our own co-founder Tom Gardner has said that if he had only one metric by which to choose his investments, it would be insider ownership. And our own Matt Koppenheffer echoed the importance of leadership by talking about CEO warning signs.

A different metric, looking to measure the same thing
Looking up insider ownership is great; you should always consider it as a data point when making investment decisions. But it's also a metric that tons of investors are already dialed in to.

My scuttlebutt -- which I don't think nearly as many investors are dialed in to -- comes from Glassdoor.com. The website accumulates employee feedback on the quality of a company's management and its culture, and then publishes the top 50 places to work based on the feedback they receive.

While it's certainly not scientific -- and it's open to manipulation -- the results of investing in these companies speak for themselves. Using the 2009 list, I took the 10 publicly traded companies with market caps under $10 billion at the time of publication (large companies are much less likely to make big moves) to see how investors would have done by buying their shares.

The results were amazing. The average total return for those 10 stocks, which included Netflix (Nasdaq: NFLX  ) and salesforce.com (NYSE: CRM  ) , over that three-year period was 189%, or 141 percentage points more than the S&P 500.

And if you think those results are good, imagine what they would look like if Netflix didn't have the meltdown it did this summer. Interestingly, the company, which was No. 3 overall on the 2009 list -- when it had an average employee rating of 4.4 out of 5 -- hasn't appeared since, and the average rating by employees has dropped to a slightly below-average 3.2 rating.

Intrigued, I figured that starting near the market bottom at the beginning of 2009 might have been a once-in-a-lifetime opportunity. So to be fair, I checked to see if the trend held by looking at the 2010 list. This group, which included Southwest Airlines (NYSE: LUV  ) and Rackspace (NYSE: RAX  ) , posted a much weaker 41% return -- but it was still enough to beat the S&P 500 by 24 points. No investor would complain about that kind of performance.

But that brings us to the outlier in our data set. Because Glassdoor has only been publishing its list since 2009, we don't have a ton of information to work with. Looking at 2011's list, the group of four small- and mid-cap stocks underperformed the S&P by 31 percentage points.

That's not surprising. Generally speaking, when the S&P 500 has a down year, it's the smaller stocks -- like the ones I focused on -- that don't do well.

But when we zoom out and take a look at stock performance over all three years, we get a compounded annual growth rate that outpaces the S&P 500 by an average of 6 percentage points per year.

Best bets for 2012
This year's list includes eight companies that are under $10 billion in market cap. They are, in order of their relative rankings: Rackspace, Salesforce, Southwest Airlines, National Instruments, Fluor, Reach Local (Nasdaq: RLOC  ) , Morningstar, and NVIDIA.

I can't stress enough how important it is that Salesforce, Rackspace, ReachLocal, and Southwest Airlines are all on the list. Of the four, Rackspace, Southwest, and Salesforce have been on Glassdoor's lists before. More important, all four are in brutally competitive fields, and they use their customer service as the key differentiator leading to business success.

Because I think quality customer service is predicated on happy employees who enjoy the culture of their company, and because I believe customer service could be the differentiator in the business world for the next decade, I'm making a positive CAPScall on all four of these companies on my profile.

If you're interested in other interesting investment options, I suggest you check out our "Top Stock for 2012." In fact, this stock, which has extensive exposure to the growing economies of Central and South America, is priced much lower right now than it was just one week ago. Snatch up shares while you can by getting your report today, absolutely free!

Fool contributor Brian Stoffel owns shares of Netflix. You can follow him on Twitter at @TMFStoffel. Motley Fool newsletter services have recommended buying shares of Southwest Airlines, National Instruments, salesforce.com, Morningstar, Netflix, NVIDIA, ReachLocal, and Rackspace Hosting, as well as shorting salesforce.com and writing puts on NVIDIA. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


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