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 Hershey (NYSE:HSY) (with a 20-year compound annual growth rate of 13.65%) 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
Hey, 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 500 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 that any company that appears to be a good investment will, in fact, succeed. In the past, many investors looked at Dell as a can't-miss, sure-thing performer. A stock that didn't know the meaning of "down." Until recently.

If a fine company like Dell, one that has rewarded shareholders for more than a decade, can fall more than 40% in just over a year, 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 17 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 1.4 and so is, by traditional metrics, overpriced.) Finally, the average company pays a historically tiny 1.7% dividend.

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

You'll find several lessons in the above chart. For one thing, growth companies in growing industries don't pay dividends. That's because they're looking to reinvest all of their free cash (if they have any) in the business. That means that your returns will be more volatile -- and that there's not much of a safety net if something goes wrong.

Analysts also expect these companies to generally post above-average growth -- and that you're generally paying a premium for that growth (as evidenced by their high P/E ratios). Not all of these companies will live up to expectations (they can't all be better than average), but those that do will probably do pretty well. It's a lot better, however, if you can buy a company that has great growth potential for a more reasonable price.

The Foolish bottom line
At Motley Fool Stock Advisor, we seek 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 18% in value since the service started a little more than three years ago, Stock Advisor picks are up an average of 56%.

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've got a free 30-day trial to Stock Advisor with your name on it. And if you're looking for the best stocks for new money now, David and Tom recently reviewed every stock on the scorecard, ranking companies on their current attractiveness. Click here to learn more.

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

Fool contributor Rich Smith owns shares of Dell. Dell and eBay are Stock Advisor recommendations. Dell is also an Inside Value pick. CNET and NetEase are Rule Breakers picks. The Fool'sdisclosurepolicy is anything but average.