How can you tell which stocks are likely to outperform? One simple way is to ask professional stock pickers with a history of beating the market.
So that's what we did. To find such pros, Money screened for stock fund managers who have not only outperformed a majority of their category peers consistently over time—over the past three and five years—but who have also beaten the stock market indexes they're measured against.
To stay ahead of the pack, stock pickers need something more than a good track record and skills: They need a disciplined process that will help them and their investment teams replicate their performance year after year.
Some of the fund managers profiled here demand a minimum level of profitability from stocks for several straight years before they'll even consider investing. Others require a high degree of financial efficiency or revenue growth.
We asked the pros who run these funds what stocks their process is identifying now. Here's what they recommend.
Blue-Chip Stocks: Eric Schoenstein and Team
Fund: Jensen Quality Growth (JENSX)
5-Year Annualized Returns: 16.0%
Expense Ratio: 0.88%
Minimum Initial Investment: $2,500
When a fund manager announces his retirement, like Jensen Quality Growth's Robert Zagunis did last year, you should typically worry about how the fund will run under new leadership. That's not the case for Jensen. Eric Schoenstein has helped manage the fund with Zagunis since 2002, and five others on the investment committee have tenures of at least nine years.
Plus, Jensen has a consistent process. Companies must have a 15% return on equity (a high standard of profitability) each year for 10 consecutive years in order to qualify for Jensen's consideration. This cuts the investment pool down from thousands of names to 230. They've taken a stake in 27 of those companies. Don't expect many utilities and energy stocks. Consumer and health care stocks typically dominate. The strategy often lags in rallies, but it served as a safer bet in the 2008 crash, when the fund fell 12 percentage points less than other blue-chip stock funds, according to Morningstar.
• Becton, Dickinson & Co. (BDX): This medical supply firm made a big splash in 2017 when it agreed to its largest acquisition ever, a $24 billion purchase of competitor C.R. Bard. That's nearly double the revenues Becton claimed in 2016. Schoenstein likes the company's scale, which helps it control prices on its syringes and vials, especially as it rolls out innovations to improve safety. While the stock is not trading at a discount to the broad market, BDX offers security since a downturn will have little impact on demand for hospital supplies.
• Microsoft (MSFT): While tech enthusiasts swoon over hot startups or the latest e-commerce fad, Schoenstein believes those plays ignore the downside. Instead, Jensen placed 5% of its stake in Microsoft because of the relationship the software giant has with businesses, creating "a steadiness" to its revenues, he says. Microsoft's growth comes largely from its cloud-computing services. While Amazon Web Services garners much of the attention in the cloud space, Microsoft expects its commercial cloud business to become a $20 billion revenue stream over the next 12 months. If that holds, it would be a 57% increase from the previous year's expectations.
Small Stocks: Robert Mitchell and Joseph Monahan
Fund: Conestoga Small Cap (CCASX)
5-Year Annualized Returns: 17.6%
Expense Ratio: 1.10%
Minimum Initial Investment: $2,500
Managers of small-company stock funds face a unique challenge: If they're truly successful, investors will fill their coffers with new money. But because these managers invest in tiny businesses, finding enough good stocks to spread around all that new money can be a challenge.
Conestoga co-managers Robert Mitchell and Joseph Monahan are facing this now, as assets have ballooned to over $1.4 billion after the fund beat its benchmark index by three percentage points annually.
New investors may soon be restricted from the small-cap fund. But Conestoga created the SMid Cap Growth Fund (CCSMX). Both funds take the same long-term view, with the managers assessing a company's potential over three to five years. Before buying, Mitchell and Monahan want to see a 15% return on invested capital—a high degree of efficiency—and prefer to invest in management teams with a 10% or more ownership stake.
Mitchell and Monahan's Picks
• Align Technology (ALGN): This maker of clear dental braces has seen sales climb 125% in the seven years since Conestoga first invested in the stock. It has done this by building a 25% market share among adults. But teens dominate braces, accounting for 75% of sales. Align's teen market share: just 3%. With new campaigns targeting teenagers (and their parents' credit cards) and orthodontic work, Monahan believes case volume will rise 15% annually over the next three years.
• WageWorks (WAGE): If you're enrolled in a health savings or flexible spending account at work, there's a good chance WageWorks runs it. Clients include 71 Fortune 100 firms, and the company enjoys a 95% annual retention rate. The stock isn't dirt cheap, but the shares are priced similarly to WageWork's slower-growing rival ADP.
• Omnicell (OMCL): Cabinets may not seem like an important cog in hospitals, but Omnicell makes ones that manage medicines flying in and out of them, helping cut theft and waste. Its newest cabinet offers automation and fingerprint controls, but their development nicked profit margins, says Monahan. As Omnicell scales up, he thinks margins will rebound.
Foreign Stocks: Nicole Kornitzer
Fund: Buffalo International (BUFIX)
5-Year Annualized Returns: 9.5%
Expense Ratio: 1.05%
Minimum Initial Investment: $2,500
At Buffalo Funds, managers start with around 25 big trends that the firm thinks will shape the long-term economic future, and then they invest in companies they think stand to benefit from those trends.
This long-term focus means that Buffalo International Fund comanager Nicole Kornitzer won't get sidetracked by what she views as short-term crises, such as Great Britain's surprising decision to leave the European Union. In fact, she used the post-"Brexit" selloff as a buying opportunity overseas.
The trends Buffalo homes in on aren't region specific, but Kornitzer must translate the impact they will have internationally.
Take the rise of the middle class in the developing world. "That's not [necessarily] on the pulse of a U.S. company" unless that business has emerging-markets exposure, says Kornitzer.
For Kornitzer, this demographic trend points to greater demand for things such as health care and luxury goods and international travel—all trends she's focused on in her fund, which has beaten 95% of its peers over the past decade.
• Grifols (GRFS): Kornitzer likes this Spanish pharmaceutical company—which collects plasma (the liquid portion of blood) and manufactures plasma-based products—in part because it lacks real competition. And though 60% of Grifols's sales come from the U.S., the firm is targeting China and other parts of Asia for growth. It has experienced a 31% surge in sales over the past two years in areas outside the U.S. and European Union. But Kornitzer advises buying the B shares offered in the U.S., as they trade at a 30% discount to the A shares in Spain.
• Yoox Net-a-Porter (YXOXY): While Amazon dominates online sales in the U.S., luxury goods remain one of the few areas the e-commerce giant has yet to conquer. Yoox—an Italian fashion e-tailer that runs, among other sites, Net-A-Porter.com, commands 10% of the online luxury market. And "no competitor comes close to its size and breadth of products," says Kornitzer. Buffalo believes this luxury e-commerce trend dovetails with rising global wealth. In its 2020 growth plan, Yoox expects a 2% gain in market share. If that's achieved, that would equate to a 20% annual revenue burst.
Emerging Market Stocks: Taizo Ishida
Fund: Matthews Asia Growth (MPACX)
5-Year Annualized Returns: 10.9%
Expense Ratio: 1.14%
Minimum Initial Investment: $2,500
With thousands of companies in Asia to choose from, how does Matthews Asia Growth begin winnowing the field? Lead manager Taizo Ishida uses a simple formula: He focuses just on publicly traded firms that have reported three straight years of double-digit revenue growth.
That screen drops the number of stocks to about 200. After that, Ishida evaluates each company, uncovering those he thinks can grow earnings 20% or more per year, over the next decade. Really, though, he's trying to identify companies that will grow from "$1 billion to $10 billion," he says.
This approach ensures his fund looks entirely different from index funds, which are tilted toward Japan. Matthews, for instance, only keeps 38% of its assets in Japan, vs. 67% for index funds. Meanwhile, the fund holds a 58% stake in rapidly developing parts of Asia, like India and China. The results: Matthews Asia returned 6% a year for the past 10 years, vs. 1.4% for the MSCI index.
• Pigeon (PGENY): In the early 2000s, this Japanese baby-bottle maker realized the risks of being tied to Japan's low birth rate. So Pigeon moved into China, where mothers give birth to over 17 million babies a year. China now accounts for 32% of sales. Pigeon sold the idea that Japanese products are safer. "People love them," says Ishida. It's not a cheap stock, but Pigeon is now expanding into India, where average births per year surpass 25 million.
• Shenzhou International Group (SHZHY): There's a good chance you've never heard of Shenzhou, but you'll recognize its clients: Nike, Adidas, Puma, and Uniqlo account for 80% of this garment producer's revenues. When Ishida invested in the company in 2010, it had a market value of $1.5 billion. That's now $12 billion. With a 20% profit margin and a new factory in Vietnam, Ishida expects sales to keep growing at a 15% annual clip.
• M3 (MTHRF): Ishida calls health care the "most exciting sector in Asia" because of a growing middle class looking for quality care. M3 connects doctors to new drugs, providing information. By reaching doctors directly, it reduces the need for sales reps, a huge cost-saver. With 4 million docs signed up, sales grew 21% over the past year, and the firm is targeting France, Japan, and the U.S.