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 for some of our readers. Newcomers to investing, on the other hand, may find that even our most basic insights into investing come as 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 all the time mentioning "the average." The average stock does this, the S&P average does that. But think for a moment on 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, it means that for every company that exceeds that mark, there's another that falls short. Some underperformers lag the S&P by just a hair. Corning (NYSE:GLW) is a good example of a company that has historically tracked the average pretty closely, while usually managing to fall just a bit short. On the other hand, other companies miss the average by a mile. To counteract this downward pull -- to push the average back up to the, um, average -- requires a steady outperformer such as Harley-Davidson (NYSE:HDI) 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
Now, 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 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 Hidden Gems, 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 companies that are all "better than average." 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 such companies will do "better than 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 you look at that appears to be a good investment will, in fact, succeed. For years, investors looked on Amazon.com (NASDAQ:AMZN) as a can't-miss, sure-thing performer. A stock that didn't know the meaning of "down." Then one fine day in February, Amazon.com reported some numbers that Wall Street didn't like, and the stock dove 15%. Oops.

If a fine company like Amazon can take a 15% hit without warning, 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 get those, click right here. 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 of 19%. It's priced at 19 times free cash flow and 20 times trailing 12 months' earnings. It's expected to grow those earnings at just under 13%. (And for those of you punching away at your calculators, yes, the average company is therefore selling at a PEG of more than 1.5 and so is, by traditional metrics, overpriced.) Finally, the average company pays a historically tiny 2% dividend.

So let's compare those numbers with a few prospective investments in, for example, the beleaguered telecom sector. I'll plug in the data for a handful of likely suspects:

The first thing this chart tells you is that telecom equipment makers aren't big on paying dividends. But that's an oversight we're willing to forgive if a company is cheap enough and generates strong cash flow. Of the four companies above, neither Juniper nor Nortel looks particularly cheap. Avaya and Cisco, on the other hand, do look intriguing. At first glance, neither one has a particularly attractive P/E or growth rate -- in fact, they look incredibly average. Yet their unassuming P/Es mask strong free cash flow ratios. To the savvy investor, this clue suggests that these companies are, in fact, trading at a discount to the broader market.

Now, mind you, all four of these companies are larger than those we typically recommend to our Motley Fool Hidden Gems members. While Hidden Gems focuses on small caps rather than the giants named above, however, the principles are similar. We seek out companies whose prices do not reflect their superior businesses, faster growth, and, in many cases, their market-beating dividends. And to date, we've done pretty well at it. While the S&P average has gained just 6% in value since we started the newsletter nearly two years ago, we're beating that number by a margin of nearly 5-to-1.

If you'd like to see how we do it, and take a look at some of the companies that have helped us to rack up these market-beating returns, you're in luck. You can access every issue we've ever printed and see every company we've ever recommended completely free of charge for one full month -- just by clicking here. If you like the service, we'd love to have you stay with us for as long as you find it helpful. If you don't, you're absolutely free to cancel anytime and receive a full refund of the unused portion of your membership. You have our word on it.

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

Fool contributor Rich Smith has no beneficial interest in any of the companies mentioned in this article. The Fool's disclosure policy is anything but average.