Painfully Obvious Stock Tips

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 what "the average" really means.

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, like Verizon over the past 10 years, lag the S&P by just a hair. Others miss it by a mile. Then outperformers such as Qualcomm come along to counteract this downward pull -- to push the average back up to the, um, average.

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. The vast majority of investors, in fact, fail to capture the market's average returns because they invest in costly mutual funds.

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.

Here's your cheat sheet
But, how, precisely, can you know which such companies will do "better than average"?

And here's the answer. There's never going to be a guarantee for a market-beating stock. (Sorry, that's not what you wanted to hear, was it?)

But for some ideas on how to improve your odds, 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 superior metrics.

For example, right now the average S&P 500 company sports a return on equity (ROE) of 20%. It's priced at 18 times free cash flow (FCF) and 19 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 roughly 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 automotive sector. I'll plug in the data for a handful of likely suspects:

Honda and Toyota growth rates from Smartmoney.com; all other data from Yahoo! Finance.

Now here's a study in contrast. Neither Daimler nor GM has generated any free cash flow over the past 12 months, and that gives both of these contenders negative P/FCF ratios. Granted, each also boasts a better-than-average dividend, but unless they can get their cash generators turned back on, you have to wonder whether those dividends are sustainable.

Meanwhile, both Honda and Toyota are mighty stingy with the dividends. Still, their valuations look attractive on both an earnings and a cash flow basis -- the caveat being that, with only one analyst projecting long-term growth rates for each of these Japanese companies, it's difficult to say how you should weigh those current valuations against future prospects. Tread warily -- no company from this group exactly leaps out at you as a painfully obvious buy.

Focusing only on the putative "leaders" in the industry might therefore lead you to reject automakers -- and all things related -- as promising investments. But not so fast. Let's consider some smaller companies on the periphery that carry valuations reflective of the mistrust investors show for the sector. Some of these companies are performing quite a bit better than the big boys. They post superior numbers not only to their beleaguered industry brethren but also to the market as a whole.

Though Winnebago and Bandag (a tire retreader) are not Hidden Gems recommendations, they are on the Watch List for their potential and could turn up as recommendations in the future. Bandag, unlike the automakers themselves, stands to profit from the increased fuel costs that seem to be hurting the industry. It takes old, bald truck tires and places new treads on them. The finished product has an expected life and fuel efficiency that is nearly indistinguishable from new tires, at a fraction of the cost. Since fitting an 18-wheeler with a complete set of tires can approach $8,000 and oil products are central to making tires, the cost of new tires is unlikely to drop as long as petroleum prices remain high. Bandag could see continued growth because of this, but of course its free cash flow numbers could certainly stand improvement.

Drew Industries is a recent Hidden Gems recommendation. The company makes, among other things, doors and parts for RV manufacturers. It sports a superior growth rate and return on equity, with an average P/E. Based solely on these numbers, Drew is the type of company that bears more consideration than the GMs or Fords of the world.

Hidden Gems recommendations are up 33% versus the S&P 500's 8% returns since inception of the newsletter. If you'd like to see how we do it, and take a look at some of the companies that have helped us 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 does not own shares of any company mentioned in this article. The Fool's disclosure policy is anything but average.