5 Companies Set to Dominate Competitors

Far too many of the gigantic companies that failed in our recent economic meltdown shared the same problem. They lost sight of their core businesses, and instead focused way too much on complicated financial engineering. In many cases, they were lured by the siren song of "significant extra profits with very little apparent risk" from derivatives and excess leverage.

As should be apparent from the sheer number of huge businesses that failed as the credit market dried up, that was a very tempting siren song, indeed. Alluringly, it played to large companies' key strengths: scale and diversification.

From billions to pennies
You see, as a company gets big, it can start taking advantage of its size. It gets better pricing on its raw materials thanks to its scale, and better terms on its loans thanks to its large cash-generating abilities. As its offerings grow over time, the chances are that its products will not all follow identical revenue cycles, and that diversification will make its operations seem less risky.

That's wonderful for the company and its investors -- up to a point. And that point arrives when the company starts thinking of ways to leverage its newfound muscle through fancy financial engineering. When that happens, the company opens itself up to the kind of excessive leverage that brought down Fannie Mae, Lehman Brothers, and Bear Stearns. Even today, the carnage continues -- look how BlackRock (NYSE:BLK) and Tishman recently defaulted on a massive Manhattan housing complex because of their excessive leverage.

After all, it's really only a small step from financial engineering to the kinds of esoteric spreadsheet-based models that "can't possibly fail outside of a black swan event."

The advantages of staying nimble
A critical factor in the meltdown was excessive debt, or "leverage" as the financial engineers like to call it. When investments work out in a company's favor, that debt magnifies the impact of the returns the company's stockholders see. Leverage looks brilliant when things are going well, but it's a knife that cuts both ways. When an investment turns against a heavily leveraged institution, even a small and otherwise manageable loss can wipe out equity almost instantly.

If a company didn't leverage itself to the hilt, however, it missed out on the magnification effects from the bubble -- and its burst. While the upside may not have appeared nearly as sweet, the downside became survivable. In addition, with a clean balance sheet that helped mute the impact of the crash, that company is now nimble enough to take advantage of the gaping holes left by its failing, overleveraged competition.

How did some avoid that siren song?
Part of what made the initial leverage so tempting was the relentless drive for growth that comes from being a publicly traded company, and thus subject to Wall Street's pressures. Wall Street can be a very difficult influence to ignore, because large institutional shareholders can force changes to a company's board and management team.

But if a company has a significant amount of insider ownership, that pressure is easier to resist. High insider ownership reduces the influence of outsiders pushing for greater leverage to juice returns. In addition, high insider ownership means the management team has a lot of its own skin in the game. As a result, as the company succeeds or fails, they personally succeed or fail.

Combine the two -- limited debt and high insider ownership -- and you have a recipe for a successful counterattack on Wall Street's pressure to "lever up."

Five companies set to dominate
Now that the damage has been done, the surviving companies have the opportunity to lick their wounds and recover -- and fill the gaps in the market left by their failed compatriots. And the companies in the best position to fill those gaps are those that survived the strongest and most intact. You know, the ones with limited debt and significant insider ownership, like these:

With a powerful combination like that, the sky's the limit as the economy turns around.

Companies like these form the core of our Motley Fool Stock Advisor service: nimble, financially strong, and run by leadership with its own skin in the game. If you're interested in owning your stake of companies like these, before they take advantage of the empty space opened up by the struggling giants, join us today. If you'd like to see who has already made the cut as a Stock Advisor selection, click here to start your 30-day free trial. There's no obligation.

This article was originally published on Oct. 21, 2009. It has been updated.

At the time of publication, Fool contributor Chuck Saletta owned no shares of any company mentioned here. The Fool has a disclosure policy.