A Strong Sign for These Stocks

With the U.S. markets having rallied for the better part of a year, with record inflows into emerging markets, it's become increasingly difficult to find strong buying opportunities.

Or has it?

In 2006, we started Motley Fool CAPS, a community-based stock-picking site. Individual investors could log on, choose which stocks they thought would outperform or underperform the market, and watch their score reflect how accurately their predictions panned out. But it's turned out to be more than just a fantasy stock market league. 

We found that four- and five-star rated stocks, as a group, have outperformed the market, while one- and two-star stocks have underperformed on average. In fact, a 2009 study by Harvard University found, among other things, "consistent evidence that CAPS picks yield information that predicts future stock market returns for individual stocks."

In other words, CAPS is a treasure trove of stock data at your fingertips -- even in this frothy market.

Vox populi
Let's look at Apple (NASDAQ:AAPL), whose turnaround over the past six years has been incredible to watch. It's gone up more than 1,700% since October 2003. In those six years, Steve Jobs, armed with the iPod, completely resurrected his company's product line -- which for years had been mired in unsuccessful launches and increasing competition from PC makers such as Dell (NASDAQ:DELL) and Hewlett-Packard (NYSE:HPQ). 

Chalk it up to Apple's stock surge or its ubiquitous products, but it's currently the most-rated stock in our 147,000-plus member CAPS community, where it's raked in over 31,000 ratings since we launched CAPS in 2006. To put that in perspective, the second-most-ranked stock, Google (NASDAQ:GOOG), has been rated only 22,500 times and General Electric (NYSE:GE), the third-most-ranked, has only 20,000 ratings.

In the nearly four years since CAPS began tracking stocks, Apple has been rated everywhere from the lowest one-star ranking to the more respectable four stars (five is the best). Now, one might expect that with so many investors rating Apple, its CAPS rating would simply reflect the ups and downs of its share price -- when the price went up, it would get a higher rating, and vice versa. Wall Street, after all, has long suspected that individual investors jump into stocks at precisely the wrong time, so it's reasonable that such a theory would play out in CAPS' rating of Apple.

As it turns out, however, CAPS investors as a whole have been pretty accurate with their calls on Apple:

Source: Motley Fool CAPS.

Yes, CAPS investors picked the wrong time to downgrade Apple in April 2009, but the move was not quite as off as you might think -- over the same period, the S&P 500 did gain 40%. Still, 39 percentage points of outperformance is nothing to sneeze at.

Even including the recent miss, in 75% (12 of 16) of the cases over a three and a half year period, a star upgrade from the CAPS community would have signaled a good time to consider buying Apple, while downgrades would have been a sign to consider selling.

It's worth noting that picks made by successful CAPS members -- those ranked in the community's top 80% (we call them "All Stars") -- have the greatest influence on the star ratings, so CAPS is more of a meritocracy than a democracy. While some CAPS members may have chased Apple's performance and lost, the "smart" money overruled those mistakes and made better calls. In doing so, it also made CAPS smarter as a database. 

And those results have been consistent across CAPS -- star upgrades are bullish indicators, and downgrades are conversely bearish.

Give my regards to Main Street
In other words, we as investors should be searching for stocks recently upgraded in CAPS. Here are three stocks that were upgraded from four to five stars in the past week:

Each of these companies has manageable debt levels, sports a return on equity of more than 10%, and trades for less than 20 times trailing earnings. At the very least, the recent upgrades of these stocks and their promising fundamentals should be seen as a strong sign for their future -- and a good reason to take a second look.

Foolish bottom line
CAPS upgrades and downgrades are definitely not automatic buying or selling signals, but you should take them as an impetus to do more research, especially when the market and the CAPS community disagree on the company's future. In these cases, either Wall Street or Main Street is missing a material piece of information -- and figuring out who has it right could lead to tremendous investing opportunities.

That's the tack we'll be taking at the Fool's newest service, Motley Fool Pro, where we'll be using proprietary CAPS data in our efforts to find the very best (and the very worst) stocks in the market. Armed with that information, we'll be investing $1 million of the Fool's money in a portfolio designed to make money in any market, using everything from equities to options to exchange-traded funds and taking long and short positions. In this type of market, we all need all the help we can get.

To learn more about Motley Fool Pro, simply enter your email address in the box below.

This article was originally published Oct. 9, 2008. It has been updated.