The Make-Your-Own Fortune 500

Have you ever toyed with the idea of profiting from the annual Fortune 500 rankings?

The list is useful as a research tool -- and perhaps as a topic of dull conversation -- but you should probably forget about it as a list of what stocks to buy or sell.

If you want a quick-and-dirty list that can help you as a retail investor, you'll have it later on in this article. But before we get to what will work, let's flesh out why investing based on the Fortune 500 (F500) is not likely to get you the returns you're looking for.

You're way late to the party
You might've made serious money on the Fortune 500 ... if you knew the 2008 rankings two decades ago. But that's not so helpful right now, huh?

You see, the companies clustered at the top of the list have already delivered fantastic returns to investors, and they did it long before their names ascended the list. Consider Wal-Mart (NYSE:WMT). Early investors are sitting on returns north of 1,500%. Now check out returns for latecomers since 2003. It's been pretty much flat -- and in all but one of those years, the company topped Fortune's list.

Basic biology explains why the F500 list won't help you: Trees can't grow to the sky, and already hugely successful companies simply can't sustain unending exciting growth rates.

Tough crowd
Wal-Mart is still a great business. But unless you're extremely good with valuations and love staring at your stocks all day, you're probably not going to make huge money as an investor in Wal-Mart or companies like it. Don't believe me? Look at a few other companies in the top 10, such as General Motors (NYSE:GM) or AIG (NYSE:AIG).

Naysayers will point to stocks like ExxonMobil (NYSE:XOM) -- currently in the No. 2 position -- and its market-beating performance of late. It's not impossible for businesses of this size to give shareholders outsized gains; it's just not as likely. The real problem is that, as an investment tool, this list is fundamentally flawed.

Flawed, I say!
The F500 places significant weight on revenue in a given year. But revenue, taken out of context, doesn't really mean anything -- earnings do. Net income is far more relevant, and although Fortune takes it into account, that variable doesn't seem to carry much weight.

Rather, investors should be looking at profits in relation to sales. And, because not all businesses are inherently high-margin, we should really focus on companies trending upward in this department -- making more in profit per dollar of sales.

But there's more.

Show me the money!
Anyone familiar with Accounting 101 can tell you that net income is a highly malleable figure -- and that's why we Fools prefer cash. The free cash flow margin will reveal just how much of every dollar in sales turns into unrestricted cash. And, like we do with profit margins, we measure the general direction in which that figure is moving.

The other metric worth watching is return on invested capital (ROIC). Any company can reinvest in its business ad nauseam and grow sales a bit -- but it's far more important that its returns on those investments exceed the costs of making them in the first place. That includes the opportunity costs of using that money elsewhere -- including returning it to you.

Again, you want to track favorable trends. Numerous studies prove that in order to get the best returns as an investor, you should side with companies with improving ROIC. In an ideal world, you'd want to be ahead of all of these trends, but just spotting them in the first place helps a lot.

The real list
Fortune's mission isn't to create a useful resource for retail investors like us. But that's our mission here at The Motley Fool. And it's the best companies -- not the biggest companies -- that have the greatest potential for outstanding returns.

So, just as I promised, here's a quick-and-dirty list that will serve as a better starting point than the Fortune 500 list will. You want stocks with:

• A relatively small market cap, so it has plenty of room to grow. Let's say less than $5 billion, but with at least $300 million for stability.
• Solid and growing free cash flow margins.
• Systematic improvements in ROIC.

When I plug these three characteristics into a stock screener, here are three names that bubble up to the top:

Data courtesy of Capital IQ, a division of Standard and Poor's.

These aren't buy recommendations -- stock screeners only provide you with a list of companies to research. But smallish companies that are making more and more money each year and getting better and better at allocating capital should be pretty darn appealing to you.

Even better, these are businesses that are constantly undervalued by the market -- and that's where you come in.

The Foolish bottom line
Owning the biggest and best of American industry has its own appeal -- I guess. But, as an investor, you probably want to orient your portfolio toward the greatest possible returns -- and that growth comes from effective operators who are gunning for their heyday at the top of the Fortune 500.

If that kind of philosophy resonates with you, I suggest you take a look the Fool's Hidden Gems investment service -- for free. At last check, Hidden Gems recommendations were outperforming like amounts invested in the S&P 500 by a full 26 percentage points. Click here to take us for a test drive -- and make your own fortune.

Fool analyst Nick Kapur loves to kick butt. Netflix is a Stock Advisor recommendation. LoopNet is a Hidden Gems and Rule Breakers recommendation. Wal-Mart is an Inside Value recommendation. The Motley Fool's disclosure policy is always at the top of the list.