3 Steps to Finding Market-Beating Stocks

The Holy Grail of investing: finding stocks that will beat the market. Every year, individuals and institutional investors pour enormous amounts of time, effort and expense into that pursuit. A majority fail. Against those odds, here's a simple, three-step process that could vastly improve your chances of achieving that goal.

Step 1: Focus on CAPS 5-star stocks
CAPS is the brainchild of Fool co-founder David Gardner, an open platform that enables members of the Motley Fool community to rate stocks and compete against each other. Players vote whether they think individual stocks will outperform or underperform the S&P 500 index. These votes are aggregated and the stocks are ranked into five quintiles according to the community's assessment of their likelihood to outperform or underperform. Not all votes are weighted equally; those from players with a successful track record in CAPS count more heavily – CAPS is a meritocracy. Each quintile gets a CAPS rating, from 1 to 5 stars (5 stars being the highest rating).

For example, customer relationship management (CRM) software provider Salesforce.com (Nasdaq: CRM) garners just 1 star. Oracle (Nasdaq: ORCL), on the other hand, which has a 16% share of the CRM market, against Salesforce.com's 11% and greater resources at its disposal, earns a 4-star rating. I know which stock I would look at first.

CAPS works! Here's the proof
Are these ratings useful? Yes, and you don't need my word for it. In 2009, three academics from Harvard and Yale performed rigorous statistical analysis on 1.2 million CAPS picks made by over 60,000 individual players. They found that 5-star stocks outperformed 1-star stocks by eighteen percentage points on an annualized basis -- a huge margin -- and concluded that CAPS participants as a group possess relevant information that isn't reflected in stock prices. Translation: CAPS has an edge over the market. Remarkably, anyone can access CAPS ratings at absolutely no cost.

Step 2: Narrowing the net
Still, of the more than 5,000 stocks that are rated in CAPS, the top quintile equates to roughly 1,000 5-star stocks – more than you want to own in your portfolio. How do you narrow this set down to a more manageable size? Start by focusing on the stocks that meet certain additional criteria to produce a shortlist of stocks with an even greater likelihood of beating the market.

The following table, for example, contains five 5-star stocks with a high earnings yield and high return on capital – two attributes that are predictive of excess stock market returns.

Source: Motley Fool CAPS and Capital IQ, a division of Standard & Poor's.
*At Dec. 21, 2010. This is an unlevered earnings yield, rather than an equity earnings yield, i.e., it is the inverse of the Enterprise Value/ EBIT ratio.

In order to put Step 2 into practice, CAPS provides you with a screener that allows you to sift through more than 5,000 stocks based on CAPS ratings and numerous other characteristics, including fundamental data, stock performance and valuation and risk measures.

Step 3: Roll up your sleeves
So far, so good: Following Steps 1 and 2 produces a shortlist of interesting stocks. Unfortunately, if you want to identify those with the absolute best likelihood of beating the index, step 3 is the most challenging and time-consuming. To this point, our search has been mechanical, which is highly efficient, but it won't tell you the whole story.

For example, in early 2009, Jeff Fischer took a close look at specialty insurer AmTrust Financial Services (Nasdaq: AFSI). What he saw was a company that had built a genuine franchise serving three niche markets: small company insurance, extended warranty coverage on consumer and commercial products and specialty middle-market property and casualty insurance.

That competitive advantage won't show up in a stock screen, but it translates into superb renewal rates -- 80%-plus for workers' compensation and 90% for extended warranties. Those numbers help to power a business through periods of economic turmoil; sure enough, in October 2008 -- the month after Lehman Brothers failed -- the company increased its dividend by 25%.

Bottom-up research: The rewards
That research gave Jeff the confidence to buy the stock for Pro's real money portfolio in April 2009, at a time when no-one wanted to own financial shares. Less than two years later, the market has rewarded Jeff's conviction with a 72% return versus 20% for the S&P 500. Despite these gains, Jeff continues to like the stock, rating it a "Buy First" -- one of the top stocks in the Pro portfolio that members should consider buying.

Your next step
It's up to you to take the next step to improving your returns. If you'd like to get more of Jeff's stock picks and learn about his approach to portfolio management – including techniques to earn extra income and reduce volatility -- add your email to the box below and we'll send you his free report. There's no obligation and I'm confident it will help you become a more successful investor, no matter how experienced you are.