This Is How You Swing for the Fences

When it comes to the top-performing stocks over the past decade, one thing is clear: They're small companies.

Hansen Natural (Nasdaq: HANS  ) and Green Mountain Coffee Roasters, two of the decade's very best stocks, both had market caps of less than $50 million back in 2000. Larger companies such as Apple (Nasdaq: AAPL  ) and Petrobras (NYSE: PBR  ) were able to deliver mighty fine returns, but nothing like the gains of their diminutive counterparts.

But there may be a darker side to the market's best stocks. Interestingly, with the notable exceptions of Hansen and Green Mountain, many of the top performers were downright ugly-looking 10 years ago. Witness this sorry display:

Company

Stock Return Jan. 1, 2000, to Jan. 1, 2010

Return on Equity for 1999

Debt-to-Equity Ratio in 2000

Range Resources 

2,246%

Unprofitable

418.0%

Terra Industries (NYSE: TRA  )

1,960%

Unprofitable

77.7%

Cal-Maine Foods 

1,813%

Unprofitable

182.0%

Middleby (Nasdaq: MIDD  )

1,643%

Unprofitable

58.3%

Walter Energy (NYSE: WLT  )

1,293%

7.9%

691.3%

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

Awww, crud
As noted above, the market's best stocks tend to come from the land of small caps. However, the chart above suggests that an investor looking for small caps with healthy financials might have missed out on many of the top performers. In fact, an investor requiring a return on equity of 10% or better, and a debt-to-equity ratio below 50%, would have had a shot at just six of the decade's top 50 stocks.

Does this mean that Foolish investors should stop looking for the best companies out there, and just start picking through the trash? I think not.

As I've said in the past, by stubbornly sticking to companies that actually produce attractive financial performance, you can still nab some top performers -- such as Green Mountain and Hansen -- while significantly cutting down your chances of gambling on a bankruptcy-to-be.

Nuts to that, you say
What's that? You say you're willing to risk getting beaned in an effort to connect with one of the next decade's grand slam stocks?

In that case, it's logical to ask whether we can figure out which stocks are destined for greatness, and which are destined for the rubbish heap.

Based on the past decade, at least, financial performance won't help us much; the financials of the big winners looked a lot like those of the duds. And while it might be tempting to draw some conclusion from the performance of natural-resources companies versus finance and technology companies, I'd worry that such an approach may be too specific to the events of the past 10 years.

However, I believe there are two things to look for in order to help identify more promising opportunities. The first is valuation -- more specifically, a low price-to-book-value multiple.

Take a gander at the enticing book value multiples that the companies above sported:

Company

Book Value Multiple in 2000

Range Resources

0.9

Terra Industries

0.2

Cal-Maine Foods

0.6

Middleby

1.3

Walter Energy

0.8

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

With the exception of Middleby, all of these stocks had book value multiples below 1. In fact, nearly 60% of the decade's top-performing stocks had book value multiples below 1 back in 2000. By contrast, only 27% of the decade's bankruptcies had a price-to-book of less than 1 at the beginning of the decade.

The second thing to look for is a reason for hope. All of the companies listed above were in dire straits 10 years ago, but each ended up not only righting its ship, but succeeding immensely since then. If a company has lousy financials, has earned other investors' hatred, and offers you no reason that it could turn things around, there may be a good chance that it won't.

Hardly foolproof
By going this route, you're wading into very troubled waters. There's a good chance you could end up with a bankruptcy on your hands. However, by snapping up a group of these companies, and not betting too heavily on any one, one or two huge winners just might carry your entire portfolio.

So to review, if you really want to swing for the fences, you'll probably want to look for a company that's:

  1. A small cap.
  2. Experiencing some sort of distress that's impacting its financials.
  3. Trading at a low book value multiple.
  4. Has some hope for a turnaround.

Though the market has been on a serious tear over the past year, plenty of stocks still match those criteria. I found a few to kick off your research:

Company

Market Cap

Return on Equity

Debt-to-Equity Ratio

Book Value Multiple

USEC (NYSE: USU  )

$650 million

4.8%

45.1%

0.5

Gushan Environmental Energy 

$92 million

Unprofitable

NA

0.3

Star Bulk Carriers 

$180 million

Unprofitable

49.5%

0.4

Dynergy 

$788 million

Unprofitable

192.7%

0.3

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

As if I haven't said it enough already, this is not an approach for the faint of heart. Of course, the best opportunities are often found where other investors can't or won't tread. So it may be that the fear factor involved in this strategy is one of its biggest strengths.

Think you know an ugly-looking company that could turn it around and be a top performer? Head down to the comments section and make your case.

Is there such a thing as a perfect stock? Rex Moore thinks he's found one.

Hansen Natural is a Motley Fool Rule Breakers selection. Apple is a Motley Fool Stock Advisor pick. Petrobras is a Motley Fool Income Investor recommendation. Try any of our Foolish newsletter services free for 30 days.

Fool contributor Matt Koppenheffer does not own shares of any of the companies mentioned. You can check out what Matt is keeping an eye on by visiting his CAPS portfolio, or you can follow Matt on Twitter @KoppTheFool. The Fool’s disclosure policy assures you no Wookiees were harmed in the making of this article.


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