This article is about beating average stock market returns, but let's begin by acknowledging how great "average" actually is. For example, $10,000 invested in the S&P 500 30 years ago -- 1991 -- would be worth over $110,000 today. And if you regularly added to your investment over those 30 years, chances are you'd be approaching retirement-ready status by now.

Average is adequate when trying to reach your financial goals. However, I believe average Joes and Janes can achieve even better-than-average returns by selectively choosing great stocks and holding them for years, allowing returns to compound.

Cathie Wood is head of Ark Invest, a company managing several funds that are popular with investors. And Ark Invest's holdings are full of great market-beating stock ideas. Among these are financial technology company Square (SQ -7.74%), streaming-TV platform Roku (ROKU -10.47%), and telehealth services company Teladoc Health (TDOC -0.75%).

An enthusiastic business person appears to celebrate something while sitting at a desk.

Image source: Getty Images.

A winning strategy to beat the market

But before diving in, if you've ever wondered why stocks go up in the first place, you're not alone. It might seem like I'm randomly rolling the dice with Square, Roku, and Teladoc, but nothing could be further from the truth. It's important to remember that profits invariably drive stock performance for long-term investors. Therefore, here's a stock-picking strategy that can beat the market: Find companies that can grow their profits for years to come.

I believe Square, Roku, and Teladoc will grow their profits at a strong pace over the coming years. Now, I don't wish to communicate that these companies are guaranteed to execute on their business plans. After all, companies can get derailed. But these three companies are proving they have what it takes.

The ability to grow profits over time can be measured in many ways, but let's just consider gross profit here. Over the past five years, Square and Roku have grown their gross profits considerably faster than Teladoc. But even though Teladoc is the laggard of this group, it's still grown gross profits at a staggering 42% compound annual growth rate (CAGR), as the chart shows.

Chart showing rising gross profit for Roku, Square, and Teladoc since 2018.

ROKU Gross Profit (TTM) data by YCharts

Growing profits from here

I believe all three of these Cathie Wood stocks can beat the market long term because they'll continue to grow profits at a market-beating pace. There are multiple ways this can be accomplished. Let's start by looking at the eighth largest holding of the Ark Innovation ETF: Square.

Square can grow its profits by first growing its revenue. According to Statista, the global digital-payments market had over $5.4 trillion in transaction volume in 2020, but the market is expected to grow to $10.7 trillion by 2025 -- nearly doubling in this five-year span. Therefore, this industry is still growing and Square's history of revenue growth suggests it will keep capturing this industry upside. For example, Square's Cash App ecosystem revenue in the second quarter of 2021 was almost 13 times what it was just two years ago. 

I believe Square will keep growing its gross profit because it will continue growing its top line. This is also true of Ark Innovation ETF's third largest holding, Roku. However, besides revenue growth, I believe Roku will grow its gross profit as its profit margin continues to improve.

In the second quarter of 2018, three years ago, Roku's gross profit margin was 50%. This isn't terrible, but it was held back because the company's low-margin hardware business made up 42% of total revenue. Fast forward to the present day, and its total gross profit margin is now 52% because its higher-margin software business now comprises almost 83% of total revenue. Not only does Roku have the opportunity to expand its margin further on this side of the business, this is also a high-growth revenue stream as consumers and advertisers make an accelerating switch from traditional TV to connected TV.

And this finally brings us to the Ark Innovation ETF's second largest holding: Teladoc. In 2020, 79% of the company's revenue came from subscription access fees; by contrast, only 19% came from visit fees. I'm highlighting this because, when discussing risks, Teladoc points out that economies of scale are achieved with growing its subscription business and not necessarily the number of visits. Taking this into consideration, look at what Teladoc has done over the last eight quarters with just subscription access fee revenue:

Quarter Q3 2019 Q4 2019 Q1 2020 Q2 2020 Q3 2020 Q4 2020 Q1 2021 Q2 2021
Revenue (in millions) $119 $127 $137 $182 $227 $316 $388 $434

Data source: Filings from Teladoc Health.

These numbers are indicative of a highly retentive subscription business and it's paying off with margin expansion, like Roku. Teladoc's gross margin jumped from 62% in the second quarter last year to 68% in the second quarter this year, thanks to this ongoing growth in subscription revenue.

However, like Square, I believe Teladoc has substantial opportunity to grow the top line in addition to expanding its profit margins. For starters, existing members are upgrading from a single Teladoc product to multiple products at a strong clip. And the company has ongoing cross-selling opportunities due to its acquisition of Livongo Health last year.

Because of these things and more, management believes growing revenue between 30% and 40% annually through 2023 is attainable -- that would put 2023 revenue at more than double what it was in 2020 while simultaneously expanding its gross margin. So put Teladoc down as a strong candidate to beat the market over this time period.

As a final caveat, gross profit isn't everything. Between gross profit and net profit, management teams have a lot of decisions to make. And poor spending could derail an entire investing thesis. So there's more to dig into with Square, Roku, and Teladoc than what can be covered here. However, it's awfully hard to beat the market unless your gross profit grows at a market-beating pace.

Square, Roku, and Teladoc are growing in this key area, and it's why they're strong candidates to beat the market.