Painfully Obvious Stock Tips

At The Motley Fool, we write for all kinds of investors. Whether you've been investing for 50 years, five years, or five minutes, you're equally welcome here.

Of course, that necessarily means that some of the topics we write about are going to seem pretty elementary to some of our readers. Newcomers, on the other hand, may find that even our most basic insights into investing are revelations. Today, I'm going to tackle a topic that longtime Fools will find painfully obvious. But obvious or not, it bears repeating.

The yin and yang of averages
The financial media are constantly mentioning "the average." The average stock does this. The S&P 500 does that. But think for a moment of what "the average" really means.

It's a composite, made up of good companies and bad. Profit makers and money losers. When we say that, on average, the stock market goes up 10% in value per year over long periods of time, that's true. And it's the reason why we advocate investing your long-term savings in the common stocks of public companies, as opposed to buying bonds or depositing your cash in a passbook savings account. Over the long term, stock investing is simply the best way to grow your money, ensure your retirement, and create wealth to hand down to your children and grandchildren.

But remember, we're talking about averages here. If 10% is the average return from the stock market, that means that for every company that exceeds the mark, there's another that falls short. When that happens, to push the average back up to the, well, average, it takes a steady outperformer such as Boeing (NYSE:BA) (with a 30-year compound annual growth rate of 18%) to come along and lend a hand.

You get the point. There are good and bad companies out there. Put 'em together, and they create the average performance.

Ain't nothing wrong with being normal
Now, there's nothing wrong with being average. If you've got better things to do with your time than grow your money to the maximum extent possible, more power to you. You can do just fine as an investor and never have to spend a minute of your life reading a balance sheet by just saving regularly and investing your savings in an S&P index fund. Put your money in there day in and day out and let it quietly grow until you retire.

Other investors, however, simply are not willing to settle for average returns. If we know it's possible to do better than the average with a little bit of effort, that prospect lures us like the Siren's call. At Motley Fool Stock Advisor, we're aiming to find and invest in only the "good" companies, to cut the losers whose dead weight drags all index funds -- and so many mutual funds -- back down to the average.

If you think Wall Street is in Lake Wobegon, you're all wet
There's no such thing as a fund composed entirely of "above average" companies. Not in Garrison Keillor's fabled Minnesota town. Certainly not among the index funds. And not in actively managed mutual funds, either.

So we repeat: If you want to beat the average, you need to invest in the common stocks of individual companies. To avoid the bad ones. To pick only the good ones. To free yourself to rise above the mundane. But how, precisely, do you know which companies will perform better than the average?

Excellent question
And here's the answer: There's no guarantee. (Sorry, that's not what you wanted to hear, was it?)

But let me finish. There's no guarantee any company that appears to be a good investment will, in fact, succeed. In the past three years, many investors have looked on Dell as a can't-miss, sure-thing performer. A stock that didn't know the meaning of "down." Until recently, that is, when the company underwhelmed Wall Street with its earnings forecast and dropped 9% in a day.

If a fine company like Dell, one that has rewarded shareholders for more than a decade, can take a multibillion-dollar hit with so little warning, then there are certainly no guarantees in this business. There are, however, ways to maximize your chances of success. And one way is to seek out companies that produce better-than-average numbers. Literally.

Here's your cheat sheet
But for that, you need to know what the average numbers are. To determine whether a company is producing better-than-average returns, you need to know what the average numbers are. (It sounds so logical, right?) Here's the latest data for the S&P 500 index, which is a good proxy for the overall market.

You can improve your investing "percentage" -- the likelihood that any given stock will exceed the average -- by comparing your prospects with this list and investing in companies with one (or preferably more) superior metrics.

For example, right now the average S&P 500 company sports a return on equity (ROE) of nearly 17%. It's priced at 18 times trailing-12-months earning and three times book value. It's expected to grow those earnings at 12%. (And for those of you punching away at your calculators, yes, the average company is therefore selling at a PEG of roughly 1.5 and so is, by traditional metrics, overpriced.) Finally, the average company pays a historically tiny 1.6% dividend.

Put average into practice
Let's compare those numbers to a few prospective investments among, for example, fashion stocks:

You'll find several lessons in the above chart. For one thing, from a GAAP earnings standpoint, Abercrombie & Fitch and Aeropostale seem to operate more efficiently than the "average" company -- their returns on equity are simply stellar. Gap and bebe are middle of the road, and Ann Taylor and Wet Seal have some work to do.

Analysts also expect these companies to generally post above-average growth. Why is that? Because these are mostly smaller companies that are focused on building out their businesses. But you'll notice that Gap -- a Motley Fool Stock Advisor recommendation -- has been left for dead within the industry. Analysts clearly think it has lost its fashion touch. Is that the case? I don't know. Fashion trends tend to wax and wane, but if Gap can get back on track, then today's price isn't bad for a company with Gap's operating history and founding leadership.

The Foolish bottom line
At Motley Fool Stock Advisor, we seek out only the best businesses for our subscribers. We're talking about companies that have superior returns on equity and low P/Es and the kind of consistent, healthy free cash flows that enable them to pay generous dividends, buy back stock, and grow their businesses. This strategy has served our members well. While the S&P 500 has gained 15% in value since the service started a little more than three years ago, Stock Advisor picks are up an average of 55%.

If you'd like to see how we do it, and take a look at some of the companies that have helped us rack up these market-beating returns, you're in luck. We're offering a free 30-day trial to Stock Advisor. Tom Gardner recently reviewed every stock on his side of the scorecard, ranking companies on their current attractiveness -- and choosing where to put new money now. David's up next with a review of his formal recommendations; you'll receive unlimited access to this and all our research from the past three years with no obligation to subscribe.

This article was originally published April 20, 2005. It has been updated.

Fool contributor Rich Smith has no beneficial interest in any of the companies mentioned in this article. Dell, bebe stores, and Gap are Stock Advisor recommendations. Gap is also an Inside Value pick. The Fool'sdisclosure policyis anything but average.