Tomorrow's Winners Aren't Where You Think

Here at The Motley Fool, our CAPS community and ratings system is something we like to think sets our website apart. It's a central part of our goal to create better-informed investors by establishing a platform where our over 180,000 members can track their picks and make pitches to argue for why they think a given stock will outperform or underperform the market. It creates dialogue and is part of what our own co-founder David Gardner calls an attempt to "Moneyball the financial world."

CAPS ratings are straightforward enough -- a one-star rating means investors think the stock will underperform the market while five stars signify that an overwhelming majority believe the stock will beat other investments. Using our CAPS Screener, I took a look at the performance of stocks over the past year based on ratings from a year ago. As the chart below indicates, the results surprised me.

Rating on 5-23-11Number That Gained in the Last YearNumber That Declined in the Last YearPercentage of WinnersAverage Return
5 stars25170426.3%(10.3%)
4 stars31170430.6%(8.6%)
3 stars29671929.1%(10.0%)
2 stars28968429.7%(10.4%)
1 star36756439.4%(8.9%)

Source: CAPS Screener. Includes stocks with market caps of $100 million or more.

Strangely, one-star stocks had a much higher percentage of winners than five-star stocks. But when you look at average returns, the disparities aren't nearly as great -- although, one-star stocks again beat out five-star stocks in terms of total return. In addition to both sheer numbers and average returns, volatility also grew as the ratings got worse, with wider spreads for both gains and losses among one-star stocks than among five-star stocks. Also notable is that the vast majority of CAPS-rated investments lost money over the past year while the S&P 500 (INDEX: ^GSPC) was essentially flat, but I'll save that subject for a different article.

Let's examine some of the key takeaways from the chart above.

Play the opponent, not just the game
Just as in other competitive pursuits such as sports, chess, or poker, the best in the game win by adjusting their strategy to their opponents'. Psychology is a huge part of the investing game -- Warren Buffett put it best when he said to be fearful when others are greedy. Finding great stocks takes more than recognizing great companies; it requires questioning the conventional wisdom of the investing community and looking for value where others are not.

A look at the list of five-star losers seems to reveal a bias toward stable businesses like pipelines, oil and gas stocks, and consumer products. Some dominant brands such as Pepsi, Procter & Gamble, and Heinz found their way onto the list as well, though all declined by just single digits. For a number of reasons including brand strength, history, and solid dividend payouts, investors tend to be bullish on these kinds of consumer goods products.

More egregious five-star slides can be seen in Chesapeake Energy (NYS: CHK) , which lost half of its value in the last year, getting demoted to four stars in the process, in large part due to the crash in natural gas prices. Based on CAPS pitches, it seems like a number of members misread how the gas boom would affect a producer like Chesapeake. Increased supplies led to lower commodity prices, which was bad news for the nation's No. 2 gas producer.

A number of five-star ETFs also struggled, including the Guggenheim Solar ETF (ASE: TAN) , which lost 75% of its value as government subsidies have slowed down and solar companies have struggled to turn profits. In the process, the ETF was downgraded to just two stars. Here, investors seemed to buy into the promises of solar as the renewable energy of the future. Unfortunately, sometimes the future forgets to show up. The industry is incredibly fragmented and is unlikely to be a good investment until consolidation happens and a profitable business model is established without government assistance.

On the flip side, we see a number of one-star winners that look like classic turnaround plays. Shares of Carmike Cinemas (NAS: CKEC) , whose theaters are mostly in rural areas, doubled over the year with almost all of that growth coming in March. Investors have been bearish on the stock since it's part of the slowly declining movie theater industry. An earnings report featuring 39% growth in operating income helped propel the stock's double.

The unbelievable growth of Pharmacyclics (NAS: PCYC) shows how a small-cap stock with loads of promise can make your entire portfolio. Shares of the clinical stage pharmaceutical company that develops cancer drugs gained 363% in the last year, and about 2,500% in the last three years. It still sports a one-star rating as investors aren't convinced its promising pipeline will ever yield tangible rewards. This argument is essentially the opposite of the consumer staples discussed above, which investors clearly prefer.

There appears to be a bias toward familiarity, history, and brand strength. The list of one-star winners also included other small pharmaceuticals such as Jazz and Infinity, which put up impressive gains of 55% and 69%, respectively.

There's no crystal ball
It's important to remember these results were taken over a one-year timeframe, but the lessons are still valuable.

As the chart above reminds us, no one can predict the future. In the last year, we've seen a number of unexpected events, including a debt ceiling standoff at home that forced a downgrade in the nation's credit rating, a metastasizing debt crisis in the eurozone that now has its tentacles wrapped around Spain (one of the world's biggest economies) and threatens to eject Greece from the shared currency, and finally a shale boom that's sent natural gas prices plummeting. Who knows what the next 12 months will bring?

A few truths in investing persist though:

  • Look for value in hidden places and avoid following the herd. The most reviled stocks can shoot through the roof overnight -- just look at what Barnes & Noble or Sears have done this year.
  • Dividends are the only guaranteed income stream in the stock market, and consistently reinvesting them pays off in the long run.
  • Diversification is the best strategy to avoid sudden losses.

Since no one knows what the future holds, investing in dividend stocks can be one of the best ways to build long-term wealth. Get a leg up on the competition with our special free report: "Secure Your Future With 9 Rock-Solid Dividend Stocks." It's got some time-tested winners you've surely heard of, and some other stocks that may be flying under the radar. You can get your free copy of the report today. All you have to do is click right here.

At the time this article was published Fool contributorJeremy Bowmanholds no positions in the companies in this article. The Motley Fool owns shares of PepsiCo and Chesapeake Energy. Motley Fool newsletter services have recommended buying shares of PepsiCo, Heinz, Procter & Gamble, and Chesapeake Energy, as well as writing puts on Barnes & Noble and creating a diagonal call position in PepsiCo. The Motley Fool has a disclosure policy. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.

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