The Dark Secret of the Best-Performing Stocks

I've seen this list of the past decade's top-performing stocks so many times, I can recite most of them from memory. But there's good reason to keep picking apart these top performers: Any one of them had the potential to turn a mediocre portfolio into a market beater.

Here's a peek at 10 of the top 25 performing stocks of the past decade:

Source: Capital IQ, a Standard & Poor's company.

The list may look pretty familiar. But you may not know that these companies, and many of the decade's other top performers, share a dark secret.

Small and powerful
All of these companies are small, and all have absolutely beaten the pants off large, well-known stocks like Procter & Gamble (NYSE: PG) and Disney (NYSE: DIS), which returned 10.7% and 10.3%, respectively, over the same period.

That's not to say that you should avoid bigger companies. Both of these companies are brand powerhouses -- Disney with its namesake brand and P&G with its massive portfolio of brands such as Gillette and Tide -- that proved their mettle by sailing through the massive global recession with nary a scuff. With price-to-earnings ratios in the midteens, they're both also much more attractive price-wise than they were back in 2000.

However, we're not looking for investments with good returns here; we're looking for the best returns. So we're going to stick with the smaller companies. But small size isn't exactly a dark secret.

So what's that dark secret?!?!
Let's take another look at the companies listed above. See whether you can figure it out:

Source: Capital IQ, a Standard & Poor's company.

What would you say ties all of these top-performing companies together?

If you said something to the tune of, "They looked like terrible investments," then you get a gold star. Even a quick glance at that chart would send chills up the spine of most fundamentals-oriented investors. Many of the companies were unprofitable, the ones that weren't produced lackluster returns on capital, and quite a few were swimming in debt.

Maybe it's not so surprising, then, that the market hated these stocks at the time. Those are some massive declines posted above, and bear in mind that this was over a period when the S&P jumped more than 50%.

There are certainly companies out there today that could fit a similar bill. Delta Petroleum (Nasdaq: DPTR), DryShips (Nasdaq: DRYS), and Leap Wireless (Nasdaq: LEAP) have all seen their stocks fall significantly over the past two years. And within those companies, we can find unprofitability, negative free cash flow, and debt problems.

But one could make a case for each of these beaten-down stocks. Delta Petroleum has struggled to find a way to profitability, even as its debt load ominously closed in. But some investors believe the breathing room that it'll get from a recent asset sale could be just what it needs to find the path to profits.

Nobody's going to mistake DryShips for the belle of the ball either, but highly levered, asset-intensive businesses like shipping have the potential to slingshot when business conditions improve.

And finally, Leap Wireless may be trudging along under a dangerously heavy debt load, but on the basis of its book value multiple, the stock looks pretty darn cheap right now.

Will these companies end up on the list of the next decade's top performers? Time will tell. For now, we can say that the ugly financials these three are showing today make them look a lot like the past decade's top performers, back when they started their own runs.

Time to scrap everything we know?
But does this mean we should forget about looking for high-quality companies trading at reasonable prices, in favor of rummaging in the garbage bin? I don't think so.

According to Capital IQ, 667 publicly traded companies with market caps greater than $10 million filed for bankruptcy protection over the past decade. In 2000, only 22 of those companies could claim a return on equity greater than 15%, and debt-to-equity below 50%. The rest of the companies that went belly up sported numbers that looked a lot like those in the chart above.

In other words, taking fliers on companies with ugly looking financials could land you a massive winner, but it also gives you a big chance of taking hefty losses.

Swing at good pitches
By sticking to investing in reasonably capitalized and solidly profitable companies that are trading at attractive prices, we vastly reduce the chances of sticking ourselves with clunkers headed toward bankruptcy, and we can still end up bagging some of the very best performers. Green Mountain Coffee Roasters and Hansen Natural, for example, both would have fit a "high quality at a reasonable price" strategy back in 2000, and they returned 9,211% and 7,024%, respectively, in the decade that followed.

What do these companies look like? Well, they look a lot like Veeco Instruments (Nasdaq: VECO) and National Presto Industries (NYSE: NPK). Like the two companies mentioned above, Veeco and Presto could have a bright future. For Veeco, that future could literally be bright as it rides the growth in markets for LED lighting and solar. For Presto -- a quirky company that sells housewares and appliances as well as defense and incontinence products -- excitement may be in short supply, but the company is a long-running story that caught fire early last decade.

But when it comes to the financial statements, Veeco and Presto are very different from Delta Petroleum, DryShips, and Leap Wireless. Both are nicely profitable, conservatively capitalized, and have exhibited significant growth over the past five years. In other words, we don't have to hope that they'll deliver strong financial performance. They already do.

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