The Dark Secret of the Best-Performing Stocks

At this point, I've seen this list of the past decade's top-performing stocks so many times that I can recite most of them from memory. But there's good reason to keep picking apart these top performers, because any one of them had the potential to turn a mediocre portfolio into a market-beater.

Here's a peek at 10 of the top 25 performing stocks of the past decade:

Company

Price Change Jan. 1, 2000,
to Jan. 1, 2010

Bally Technologies

5,975%

XTO Energy (NYSE: XTO  )

5,917%

Southwestern Energy

5,776%

Clean Harbors

4,669%

Deckers Outdoor

3,775%

Jos. A Bank Clothiers

3,196%

Range Resources

2,246%

FTI Consulting

2,022%

CarMax

1,997%

Terra Industries (NYSE: TRA  )

1,960%

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

The list may look pretty familiar, but what you may not know is that these companies, and many of the decade's other top performers, share a dark secret.

Skeletons in the closet
If you're thinking I'm going to say that all of the companies above were small and that they beat the pants off of large, well-known stocks likeProcter & Gamble (NYSE: PG  ) and Disney (NYSE: DIS  ) (which returned 10.7% and 10.3%, respectively), I'm not. It's true, but a number of my colleagues have already done a great job highlighting that very important aspect.

So what is the secret, then? Instead of simply telling you, let's take another look at the companies listed above and see if you can figure it out.

Company

Price Change Jan. 1, 1998, to Jan. 1, 2000

Return on Equity in 1999

Debt-to-Equity in Early 2000

Bally Technologies

(84.1%)

Unprofitable

Negative book value 

XTO Energy

(45.5%)

19.5%

340.8%

Southwestern Energy

(49%)

5.3%

140.5%

Clean Harbors

(20%)

Unprofitable

230.2%

Deckers Outdoor

(65%)

5.3%

14.6%

JoS. A. Bank Clothiers

(44.2%)

3.2%

35.9%

Range Resources

(80.4%)

Unprofitable

417.5%

FTI Consulting

(60%)

2.9%

206.7%

CarMax

(74.3%)

Unprofitable

62.2%

Terra Industries

(88%)

Unprofitable

77.7%

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

Now what would you say ties all of these top-performing companies together?

If you said something to the tune of "they looked like terrible investments," then you get a gold star. Even a quick glance at that chart would send chills up the spine of most fundamental-oriented investors. Many of the companies were unprofitable, the ones that weren't produced lackluster returns on capital, and quite a few were swimming in debt.

Maybe it's not so surprising, then, that the market hated these stocks at the time. Those are some massive declines posted above, and bear in mind that this was over a period when the S&P jumped more than 50%.

Time to scrap everything we know?
Does this mean that we should forget about looking for high-quality companies trading at reasonable prices in favor of looking in the garbage bin? I don't think so.

The list of the decade's top-performing stocks isn't the only place where lousy returns on equity and high debt levels show up. You can also find numbers that look like that on a list of the decade's bankruptcies.

According to Capital IQ, there were 667 publicly traded companies with market caps above $10 million that filed for bankruptcy over the past decade. In 2000, only 22 of those companies could claim a return on equity above 15% and debt-to-equity below 50%. The rest of the companies that went belly up sported numbers that looked a lot like those in the chart above.

In other words, taking fliers on companies with ugly-looking financials could land you a massive winner, but it also gives you a big chance of taking hefty losses.

Swing at good pitches
By sticking to investing in reasonably capitalized and solidly profitable companies that are trading at attractive prices, we may miss out on some of the biggest winners, but we also vastly reduce the chances of sticking ourselves with clunkers headed toward bankruptcy.

And don't worry, there are still plenty of opportunities for big returns. With gains of 9,211% and 7,024%, respectively, Green Mountain Coffee Roasters (Nasdaq: GMCR  ) and Hansen Natural (Nasdaq: HANS  ) were two of the very best performing stocks of the decade, and both would have fit a "high quality at a reasonable price" strategy back in 2000.

Of course, even companies that produce good-looking numbers can end up being poor investments. Ten years ago, the numbers all seemed to line up for American Capital (Nasdaq: ACAS  ) and Ethan Allen Interiors, but both stocks ended up getting clobbered.

That's why the team at the Motley Fool Hidden Gems newsletter not only focuses on companies that produce attractive financial returns, but also digs in to evaluate intangibles like competitive moat, growth opportunities, and management effectiveness. The team's research recently led it to buy shares of a fashion retailer for the newsletter's real-money portfolio.

To take a peek at that stock, and all of the recent moves and recommendations at Hidden Gems, you can take a free 30-day trial.

Fool contributor Matt Koppenheffer does not own shares of any of the companies mentioned. Disney and CarMax are Motley Fool Inside Valuepicks. Green Mountain Coffee Roasters and Hansen Natural are Rule Breakersrecommendations. Walt Disney is a Stock Advisor pick. Procter & Gamble is an Income Investor pick. The Fool owns shares of Procter & Gamble and XTO Energy. The Fool's disclosure policy assures you no Wookiees were harmed in the making of this article.


Read/Post Comments (22) | Recommend This Article (86)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On March 25, 2010, at 6:52 PM, Rundog999 wrote:

    So, which of these top-performing stocks did MF Hidden Gems recommend while they were down and out?

  • Report this Comment On March 25, 2010, at 7:10 PM, TMFFischer wrote:

    All right, Matt, I'll say it. Great article! You typically earn those types of returns by taking very large risks, and more often than not, you're going to lose money by taking those risks. Screening for the best-performers the past 10 years tells you little unless you look at how the businesses were doing the years prior -- you had to be really contrarian and roll the dice on some dogs. Great insight.

    (Of the many ways to skin the cat, Hidden Gems and Rule Breaker-type stocks may get you to the same general results on some selections -- over the years -- but often with much less risk.)

  • Report this Comment On March 25, 2010, at 8:56 PM, TMFKopp wrote:

    Thanks Jeff. Frankly I was caught a little by surprise by what I found.

    But you hit the nail right on the head:

    "You typically earn those types of returns by taking very large risks, and more often than not, you're going to lose money by taking those risks."

    The Buffett/Graham crowd knows that higher returns doesn't always mean higher risk -- sometimes it means more and better legwork. But sometimes, as I think these results suggest, higher returns does simply mean swallowing more risk.

    Matt

  • Report this Comment On March 25, 2010, at 11:21 PM, GregTrocchia wrote:

    A very interesting find indeed. This leads me to suggest a possible follow up: Obviously, at some point during this last decade, all 10 of those stocks on your list must have ceased to look like dogs (at least in terms of price change and, I suspect, also in terms of ROE and Debt to Equity as well).

    How much of those big profits over the past decade would one have had to forgo in order to purchase them after their circumstances had changed. If enough of the price appreciation comes after the company is no longer a basket case, it may be worth looking for companies that used to be horrors for which circumstances have changed.

  • Report this Comment On March 25, 2010, at 11:23 PM, GregTrocchia wrote:

    A very interesting find indeed. This leads me to suggest a possible follow up: Obviously, at some point during this last decade, all 10 of those stocks on your list must have ceased to look like dogs (at least in terms of price change and, I suspect, also in terms of ROE and Debt to Equity as well).

    How much of those big profits over the past decade would one have had to forgo in order to purchase them after their circumstances had changed. If enough of the price appreciation comes after the company is no longer a basket case, it may be worth looking for companies that used to be horrors for which circumstances have changed.

  • Report this Comment On March 26, 2010, at 1:47 AM, TMFKopp wrote:

    @GregTrocchia

    Great point Greg and definitely worth looking into. Looks like I've got a new project now!

    Matt

  • Report this Comment On March 26, 2010, at 9:31 AM, MORK000 wrote:

    ANYONE COULD GO BACE 5 OR TEN YEARS LOOKING UP DIFFERENT STOCKS AND PICK WINNERS. EVEN A DUMMY LIKE ME!

  • Report this Comment On March 26, 2010, at 2:03 PM, TMFKopp wrote:

    @MORK000

    Not exactly sure what your point is, but just like in any other endeavor, there are things we can learn from history.

    In this case, it's finding the companies that have performed the best over the past decade and saying "10 years ago, what did these companies look like?" As my colleagues have noted on a number of occasions, these stocks tend to be small. As I've reviewed above, many of the companies looked, frankly, like crap -- lots of debt, not a lot of profits, etc.

    Then we move onto: Well, what can we learn from this? The answer that I've come to here, is that in order to chase down some of the very best performers, it appears necessary to have a mighty big appetite for risk. So, investors with a less pedal-to-the-metal risk appetite may want to instead look for small companies with good, or at least promising, financial performance, knowing that they may not score THE best performers of the next decade, but on balance they will likely have more successes and fewer failures.

    Matt

  • Report this Comment On March 26, 2010, at 4:30 PM, ElCid16 wrote:

    Personally, the professional service that I would be most inclinced to purchase from TMF would actually be Hidden Gems. I'm young, willing to tolerate a bit of risk, and I feel that devoting a large portion of my equities portfolio to small caps could do me well in the long run. I'd love to be able to line up a few of the small caps that I'm interested in with your recommendations, just as a solid second opinion if nothing else. The only thing that's held me back is the fact that it has performed so poorly vs. the S&P 500 when compared to all the other services that you guys offer. Other than Rule Breakers or Stock Advisor (which both seem to be very successful, I'd like to add), I don't don't think I'd consider paying for any of the other services.

  • Report this Comment On March 26, 2010, at 5:49 PM, mountain8 wrote:

    Hello,

    Great article and comments.

    I tend to gamble once in a while with money I can afford to lose. I don't have the mathmatical abilities you have nor the research materials. I am curious though:

    If I invested $100 each in 100 of these losers ($10,000.00) and one of them returned say 5,000% with all the rest bankrupting, would I win or lose? Point in time is not important, i.e. buy first issue on Jan 1 1956 and the last on Jan 1 1999 (that's just an example for demonstration. Pick any reasonable timespan you want. The % return is really all I'm curious about).

    I realize this is just bare bones and not all the 99 would bankrupt. Dividends, splits and etc would occur. I just don't know how much time and variables I can talk you into spending on this problem. If you have the time and this interests you, you could do this for real by randomly picking 100 "loser stocks", fitting your criteria, from the past, say 50 years, and see what the actual total return would have been.

    Essentially the Dart Throw Picking Theory with the worst possible picks (save one miracle) from your darts. Might make an interesting article... Might be an interesting result...

  • Report this Comment On March 26, 2010, at 5:56 PM, mountain8 wrote:

    dkilgour16,

    I'm like you and can't afford much in the line of paid-for-services. However I will say this, with the free services and SA, I have found more than enough information, data, and tools to make anybody as good a picker as anybody else.

    That said, I believe the rest of the world is a great possibility and it is wise to have a managible % of my portfolio invested so. I am currently trying to get myself into a position where I can afford to rent my second advice service... Global is already my choice. The other specialties services are for people with a bit more risk tolerance than me. Good Luck whatever.

  • Report this Comment On March 26, 2010, at 5:58 PM, mountain8 wrote:

    Rundog999

    Hidden Gems hasn't been around long enough to have participated in any of these.

  • Report this Comment On March 26, 2010, at 6:28 PM, TMFKopp wrote:

    @mountain8

    I ran the numbers really quickly and it looks like you'd be pretty disappointed in those results. Your one big winner would have turned your $100 investment into $5,100. However, by investing in 100 at the beginning, you would have invested $10,000. So taking that approach, you'd have lost almost half your money.

    @dkilgour16

    "The only thing that's held me back is the fact that it has performed so poorly vs. the S&P 500 when compared to all the other services that you guys offer."

    FWIW, the return on the HG portfolio is a little funny. Last year, HG changed from just recommending ideas to running a real-money stock portfolio. The team wanted to make the portfolio as useful to subscribers as possible so they opted to invest the money over time rather than all at once. While I happen to think that's a more useful model, it has also left the portfolio in cash while the market ran up.

    So the short answer to your issue is that a good chunk of HG's underperformance versus the S&P is having cash on the sidelines as opposed to picking terrible stocks. Doing a quick calc on the HG portfolio, it looks like, on average, the stock picks in the HG portfolio have beaten the S&P by about 4.8%.

    Working for TMF I'm obviously a bit biased, but if you want to take a look for yourself, we let you try the service for a month for free. (http://www.fool.com/shop/newsletters/04/index.htm?source=ihg... -- same link as above).

    Hope this helps.

    Matt

  • Report this Comment On March 26, 2010, at 7:03 PM, wolfman225 wrote:

    Hey, Matt. Care to comment on my picks on CAPS? I've tried to follow the Fool's general advice on only carrying as many stocks as I can reasonably follow. Which means that the only award I have is the rather dubious bomb for no picks in 90 days. So far, I have only one loser (it's early days, yet), AT&T (T), which is down a fraction. ALL of my other picks are up, including some which have done very well, indeed. Half of my picks are up double digits, including one, Werner (WERN) that I included because I have it in RL (I'm an employee and get a GREAT deal: Immediate 15% match on all purchases, no restrictions on when I can sell, and my employer covers all brokerage costs. SWEET) even though it's only rated one star.

    With these results, I should be fairly content, but I'm still just above the "beanie" stage and lagging the S&P. Any suggestions?

  • Report this Comment On March 26, 2010, at 7:34 PM, Friendlysurfer wrote:

    I like the HG and the Stock Advisor, and my money as well. And I am in the business longer than the Fool can imagine. Cheers, Karel

  • Report this Comment On March 26, 2010, at 7:59 PM, wolfman225 wrote:

    Quit spamming. Take that bs over to MSNBC

  • Report this Comment On March 26, 2010, at 11:03 PM, TMFKopp wrote:

    @wolfman225

    Regarding CAPS in particular, while it can be treated as a more traditional portfolio tracker / stock market game, I think a lot of people have made a lot more calls on CAPS than they would care to hold in their actual portfolios (I have for sure). I only mention that because if you can do it well, making calls on more stocks gives you the opportunity to rack up more total points.

    Though I should also note that accuracy is very important.

    I noticed that many of your picks have pitches on them and that's great. Though I haven't been great about putting pitches with all of my CAPS picks, I've found that one thing that has helped my investing is to always have not only a well-though-out but written and recorded thesis for making the investment. This makes it a lot easier to later review my work and make tweaks to what's working and what's not in my approach.

    Bottom line, though, if you're looking for suggestions on bettering your CAPS score, I'd say go ahead and make a bunch more picks. But don't do it blindly, do some research, and come up with some good reasoning behind your calls. There's a good chance this'll help your CAPS score, but more importantly you'll get to learn about a whole lot of new stocks.

    Hope this helps-

    Matt

  • Report this Comment On March 27, 2010, at 8:14 AM, maxanova wrote:

    I ENJOY SOME OF YOUR AD-VICE BUT:

    sorry, NOT your REPEATED past statistics no problem finding suxesful companies on a scale of 10 years.

    DIS -A -POINTED

  • Report this Comment On March 27, 2010, at 12:31 PM, mountain8 wrote:

    TMFKopp

    Thanks.

    Half my investment returned assuming all the rest become valueless. I Wonder what the odds are of the other 99 really returning nothing? Might be a reasonable gamble after all. What do you think.

    Remember, I'm talking gamble not investing or even speculating. I agree it would be a totally irresponsible move. But I'm just having a little fun with a irrational thought.

  • Report this Comment On April 02, 2010, at 2:19 AM, TMFKopp wrote:

    @mountain8

    Here's a follow-up article I did that goes into a little more detail on some things to look for if you did want to try and bag some of these rocket shots.

    http://www.fool.com/investing/high-growth/2010/03/31/this-is...

    Matt

  • Report this Comment On March 20, 2011, at 5:08 AM, louchios50 wrote:

    The most important thing these companies share is they offer a service/product with extrodinary consistancy that people want... such as GMCR and AIS which will be huge winners.

  • Report this Comment On February 03, 2014, at 12:40 AM, Hamoody wrote:

    So Matt, I am new to the investment world and I am curious as to how helpful it is to go back in time to study past case studies of stocks that made big retruns?

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