The Secret of Millionaire-Maker Stocks

We know from four years of confirming research by my Foolish colleague Tim Hanson that the best stocks to buy and hold for the long term begin as ignored and obscure small caps.

But that can't be all there is. Any micro-cap can be small and ignored. And not all well-managed, cash-conscious small caps make for multibagger returns. Just ask me about Secure Computing some time.

"There has to be something more to the very best of the best," I thought when studying this year's list. So I didn't stop there. I revisited the market's 10 best for the decades ending in 2005, 2006, and 2007.

What I found might help you to crush the market.

Here's what I found
Eight stocks made Tim's list more than once, including biotech Celgene (Nasdaq: CELG  ) . Two earned three-peats. But only Hansen Natural, creator of a whole category of natural beverages, managed a four-peat.

And not just any four-peat. Hansen has topped Tim's list every year. The investor lucky enough to have bought $10,000 worth of this stock on Jan. 3, 1996 would have more than $4 million today.

What made Hansen so special? Growth. Sexy, beautiful, ginormous growth coupled with very high returns on capital:

Year

Revenue Growth

Return on Capital

Trailing 12 mos.

26.8%

37.5%

2007

49.3%

44.1%

2006

73.6%

56.4%

2005

93.5%

69.8%

2004

63.4%

45.5%

2003

19.9%

18.1%

2002

14.1%

10.4%

2001

12.5%

10.9%

2000

(0.8%)

16.5%

1999

34.2%

26.1%

Source: Capital IQ, a division of Standard & Poor's.

The secret of a millionaire-maker stock
Management's decision to enter the market for "functional beverages" like energy drinks in April of 1997 may have been the catalyst. Interestingly, it wasn't the first to do so. Austria's Red Bull was an established leader in Europe and was winning customers here when Hansen entered.

But the U.S. was an emerging market for functionals, and Hansen CEO Rodney Sacks found an edge over Red Bull. His team focused on the taste, branding, and distribution of its flagship Monster Energy drink. Hansen differentiated itself from Red Bull and other competitors by blending its energy drinks with citrus-flavored fruit juice, introducing large cans with a hardcore look to appeal to younger customers, and utilizing unconventional promotional tactics like giving away free samples at convenience stores and sponsoring X Games athletes.

Buzz followed. Then, orders. Lots and lots of orders.

Hansen, in other words, helped shape a new multi-billion-dollar category early in its development. Fool co-founder David Gardner has a name for firms like these: Rule Breakers.

I had my answer. The best stock of the decade, four years running, was more than just small, obscure, and ignored. It was also a rebel.

How to find today's best
I take three lessons from this narrative:

  1. High growth is best when coupled with high returns on capital.
  2. The very best small stocks are the ones creating new industries.
  3. You don't have to rush to buy the biggest winners.

Indeed, you could have waited until two years after Hansen's functionals rolled out to buy and would still have enjoyed the largest multibagger of the last 10 years.

Today's investors have the same opportunity. Each of these five small caps is like the Hansen of a decade ago -- growing fast and known for effective capital allocation:

Company

2-Yr. Revenue Growth

2-Yr. Est. Revenue Growth

Return on Capital

AmSurg (Nasdaq: AMSG  )

16.6%

21.0%

17.6%

Atwood Oceanics (NYSE: ATW  )

37.5%

35.3%

19.0%

Mercadolibre (Nasdaq: MELI  )

62.2%

57.0%

23.2%

PetMed Express (Nasdaq: PETS  )

16.8%

26.6%

27.3%

True Religion (Nasdaq: TRLG  )

38.6%

21.5%

36.3%

Source: Capital IQ, a division of Standard & Poor's.

Interestingly, Mercadolibre is already a pick of David's Motley Fool Rule Breakers service. I mention this because in my screening for the next Hansen, Capital IQ found that eight current Rule Breakers picks passed my tests, which were:

  • Listing on a major U.S. exchange.
  • A market cap greater than $150 million.
  • Historic revenue growth above 15% over the past two years.
  • Current return on capital above 15%.
  • Estimated revenue growth above 20% over the next two years.

The bad news? Some low-rated stocks also qualified, including NVE (Nasdaq: NVEC  ) , a one-star stock according to our 130,000-strong Motley Fool CAPS community.

Obviously, it takes more than a good screen to find rebel stocks. That's why David's team goes seven-deep. We depend on each other to go beyond the financials and study the likelihood of disruptive change occurring.

Care to learn more about the process? Click here for 30 days of free access to Rule Breakers -- you'll get unfettered access to all of our research, as well as our team's five top growth stocks for new money now.

This article was originally published Jan. 23, 2009. It has been updated.

Fool contributor Tim Beyers didn't own shares in any of the companies mentioned in this article at the time of publication. Tim is a member of the Rule Breakers team, which counts Mercadolibre and Hansen Natural among its recommendations. Mercadolibre is also a Motley Fool Global Gains pick. Atwood Oceanics is a Stock Advisor selection. The Motley Fool has a disclosure policy.


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  • Report this Comment On March 25, 2009, at 4:51 PM, IBJAMMIN wrote:

    NVEC is a very interesting company. They have what may become a new disruptive technology for memory chips that is smaller, faster and uses less energy. Even better, how many stock are at the same prices they were last summer. If you added during the downturns you have great returns. I recomend other Fools learn about and consider investing in NVEC.

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