The 10 Hottest Stocks Right Now

I set out to find the hottest stocks in the market right now.

I looked for the top performer over the past 12 months for each sector, with only these restrictions: The company had to have a market cap of at least $200 million a year ago and sell on a major U.S. stock exchange.

You may be surprised that shares of some of your favorite rebounders weren't hot enough to make the list. Without further ado:

Sources: Capital IQ (a division of Standard and Poor's) and Yahoo! Finance.
Returns from April 30, 2009, to April 30, 2010.

Those are some blistering returns, to be sure. But they won't help us today -- unless their runs continue. The question remains: Will the hottest stocks right now be the hottest stocks a year from now?

Let's take a quick step back to see what happened with 2008's winners.

Sources: Capital IQ (a division of Standard and Poor's) and Yahoo! Finance.

All right, that's a lot of data to look at. Let's summarize it into three quick bullets:

• None of 2008's big winners made 2009's list.
• As a group, they got trounced by the market.
• Only two of 10 beat the market; seven had negative returns.

I don't show you this data to try to extract any speculative rules from one year's worth of data. It's just a reminder that momentum eventually breaks. Jumping into the hottest thing around frequently looks good for a while. Until it doesn't.

The housing bubble taught us that on a grand scale.

The exception
There's a problem with ignoring this past year's hottest stocks, though. Sometimes a hot stock is an amazing growth-stock story. And sometimes an amazing growth-stock story looks just like a bubble.

Here's a quick example from recent history: There's an IPO and shares increase by 300% in less than two years ... despite a huge post-IPO market crash. If you refused to get in, you would have been somewhat vindicated the next year. The stock fell 3%. Then it went up another 500% in the following three-year period!

That was the Microsoft story from 1986 to 1991, well before its bubble-assisted growth in the late '90s.

And another exception
It can also be easy to ignore growth stocks because they frequently look expensive using measures like price-to-earnings ratios -- especially after big runs.

As their name suggests, growth stocks require years of high growth to justify those lofty valuations. When Motley Fool co-founder David Gardner recommended Intuitive Surgical in his Rule Breakers newsletter back in 2005, it had a P/E ratio of 71. However, its earnings have grown by so much that its P/E ratio is now lower after a greater-than 600% share price increase. Nice.

That's not always the case. More often than not, a stock with a P/E ratio of 71 is just plain overvalued.

Given that many of the hottest stocks I identified above have expensive P/E ratios, how do we tell the difference between an overvalued, bubblicious stock, or a stock like Microsoft in 1986 or Intuitive Surgical in 2005?

I went back to David Gardner -- the guy who named his newsletter Rule Breakers -- for the answer. The stocks he's willing to pay up for are the ones that are "truly disruptive in their industries." In other words, these companies break the rules that their competitors cling to.

We all know how Microsoft disrupted the computer industry. Intuitive Surgical's business is replacing human surgeons with robots. I'd call that pretty darn disruptive as well.

Finding the true disrupters
Keep these examples of true disrupters in mind as you try to determine whether the latest hot stocks will be the hot stocks of next year and beyond. Those that are priced for growth need to back it up with true rule-breaking.

At this point, you're probably wondering whether any of today's hottest stocks are on David's list of true disrupters. The answer is no. Not yet, at least.

If they ever do make the cut for his Rule Breakers newsletter, though, note that the type of investing David does is not for the faint of heart. He's not going after bunts and singles. He's swinging for the fences. That means he makes his share of strikeouts. His philosophy is that the home runs more than make up for the strikeouts.

That's been the case so far. Since he started Rule Breakers in 2004, he's beaten the market by 22 percentage points. If you'd like to join him in stalking the long ball (and see all his recommendations), click here for a 30-day free trial.

This story was originally published Dec. 10, 2009, as "Will 2009's Hottest Stocks Be 2010's?" It has been updated.

Anand Chokkavelu owns shares of Intuitive Surgical and Microsoft. Intuitive Surgical is a Motley Fool Rule Breakers pick. Microsoft is a Motley Fool Inside Value recommendation. Motley Fool Options has recommended a diagonal call position on Microsoft. The Fool owns shares of Prestige Brands Holding and has a disclosure policy