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The Wrong Place to Look for Great Stocks

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Top-performing stocks can deliver market-beating returns for years. But discovering which stocks will be tomorrow's best performers isn't as simple as just looking at yesterday's returns. Often, the great stocks of the future look downright ugly today. And on the other side of the coin, you can't necessarily count on what looks like a great track record of strong performance to continue in the months and years to come.

Chasing performance
Beginning investors often fall into the trap of basing their investment decisions on past performance. Just take a look at the current craze among many investors: Treasury bonds. Much of the clamor over Treasuries has come from the fact that while stocks haven't done much of anything this year, Treasuries are up strongly, with double-digit gains on longer-term bonds. Those returns are unlikely to continue, but it hasn't stopped investors from adding hundreds of billions of dollars to bond investments this year.

The same thing happens with stocks. When oil topped $100 per barrel in 2008, commodities stocks soared, and no matter how high they went, optimists saw more room for gains. Eventually, though, the bottom fell out of the market, and those stocks dropped sharply, hurting those who tried to catch the wave late in the game.

Conversely, sometimes, you'll find stocks that have performed terribly in the past but that have promise for the future. If you can ignore their bad track record and focus solely on what tomorrow may bring, you could uncover a path to great wealth.

Yesterday's losers, tomorrow's winners
As an example, let's go back to 2005. The stock market had finally started to recover from the bursting of the tech bubble from 2000 to 2002, and although the S&P 500 hadn't come close to regaining all of its bear market losses, it had made great strides in that direction.

If you'd had to pick stocks back in 2005 that looked like they'd be among the market's top performers over the ensuing five years, you probably would have passed over these stocks:

Company

Total Return, 2000 to 2005

Total Return, 2005 to 2010

priceline.com (Nasdaq: PCLN  )

(86.8%)

1,302%

Illumina (Nasdaq: ILMN  )

(71.1%)

628%

F5 Networks (Nasdaq: FFIV  )

(17.2%)

327%

Dollar Tree (Nasdaq: DLTR  )

(45.8%)

189%

Big Lots (NYSE: BIG  )

(16.9%)

154%

Red Hat (NYSE: RHT  )

(42.6%)

140%

Source: Yahoo! Finance, as of Aug. 25, 2000; Aug. 26, 2005; and Aug. 25, 2010.

These stocks all had performed abysmally in the first half of the decade. Many of them are tech companies that suffered collateral damage from the tech bust yet found ways to survive and even prosper in its aftermath. Dollar Tree and Big Lots, on the other hand, owe their bad performance to an improve economy in which consumers tended to prefer higher-priced retailers. Certainly in 2005, there were few signs that the economic expansion would ever come to an end.

Investors who focused on the future, however, were able to reap big rewards. Priceline reinvented itself, carving out a niche with the help of William Shatner while offering many of the same services its competitors did. F5 survived the tech bust and found its bearings in the networking market, while Red Hat has managed to keep Linux living throughout the decade. Illumina turned the megatrend of genetic sequencing into higher margins and a competitive edge over rival Life Technologies (Nasdaq: LIFE  ) . And those discount retail chains hit paydirt when the economy dove.

Don't miss out
It's easy to justify buying stocks that have performed well recently, in the belief that they'll keep on chugging away and producing further gains. It's a lot harder to go against the crowd and put your hard-earned money into a flagging stock that has seen brighter days.

As tough as it is, that kind of conviction in your investments is what separates decent investors from great ones. By dismissing the past and looking forward to what's to come for a company, you'll often find great stocks that others pass up.

Buffett and tech stocks go together like oil and water. But Alex Dumortier has found one tech stock that Buffett likes.

Fool contributor Dan Caplinger has a tendency to be in the right place a little bit early. He doesn't own shares of the companies mentioned above. Illumina and priceline.com are Motley Fool Stock Advisor choices. Try any of our Foolish newsletters today, free for 30 days. The Fool's disclosure policy is your GPS navigation system to smart investing.


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Dan Caplinger
TMFGalagan

Dan Caplinger has been a contract writer for the Motley Fool since 2006. As the Fool's Director of Investment Planning, Dan oversees much of the personal-finance and investment-planning content published daily on Fool.com. With a background as an estate-planning attorney and independent financial consultant, Dan's articles are based on more than 20 years of experience from all angles of the financial world.

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Related Tickers

12/22/2014 4:01 PM
BIG $38.92 Up +0.53 +1.38%
Big Lots CAPS Rating: ***
DLTR $69.09 Up +0.39 +0.57%
Dollar Tree Stores CAPS Rating: ****
FFIV $132.97 Up +0.22 +0.17%
F5 Networks CAPS Rating: ***
ILMN $189.43 Down -0.54 -0.28%
Illumina CAPS Rating: ****
LIFE.DL $0.00 Down +0.00 +0.00%
Life Technologies… CAPS Rating: ***
PCLN $1149.38 Up +39.93 +3.60%
Priceline Group CAPS Rating: ***
RHT $68.89 Up +0.85 +1.25%
Red Hat, Inc. CAPS Rating: ***

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