Marshall Hargrave: Investing in the biggest and best company can be a great way to protect against large selloffs in stocks. However, underdog stocks offer investors the best chance of beating the market.
Many investors believe that owning the biggest and best is a foolproof way to beat the market. However, bigger is not always better when it comes to the stock market. Certain underdog stocks can offer better returns.
Take McDonald’s (NYSE: MCD) for example, which is the largest fast-food burger joint in the world. But the likes of Jack in the Box (NASDAQ: JACK), Burger King Worldwide (NYSE: BKW) andWendy’s (NYSE: WEN) have all outperformed the industry leader over the last five years.
Stocks in an industry become underdog stocks when the market overreacts, lowering expectations and turning the stock into a value play.
And who doesn’t like a good underdog story?
There’s a reason that Rudy is one of the most popular sports movies of all time. Investors willing to step outside their comfort zones can find impressive upside with three of the top underdog stocks in today’s market:
Underdog Stock No. 1: Rite Aid Corp. (NYSE: RAD)
This drug retailer is the third-largest player in the United States. Shares are down 18% over the last month after the company offered lower-than-expected earnings guidance for the full year.
And although it’s much smaller than its major peers, CVS (NYSE: CVS) and Walgreen (NYSE: WAG), it is the cheapest. Rite Aid shares trade at a forward P/E ratio (price-to-earnings based on next year’s earnings estimates) of 13. Its P/E-to-growth rate (PEG) ratio is a mere 0.5.
Rite Aid’s recent focus has been on selling private-label products and opening GNC store-in-a-stores.. Almost 20% of its sales are from private-label Rite Aid products, which carry higher margins.
As far as GNC goes, Rite Aid has over 2,200 GNC store-in-a-stores — which covers almost half of its store base.
The beauty of its GNC partnership is that the shift toward healthier living and the aging of Baby Boomers will help boost the demand for vitamins and supplements. Its continuation of store remodels should also help with getting new customers into its stores.
Underdog Stock No. 2: Outerwall Inc. (NASDAQ: OUTR)
Outerwall is another interesting underdog story. It runs a number of kiosk businesses that are meant to tap into America’s rising demand for convenience. It all started with its coin-counting kiosks, Coinstar, located in grocery stores across the country.
Its staple business has become Redbox, accounting for over 80% of company-wide revenues. Its Redbox business is currently battling Netflix (NASDAQ: NFLX). Outerwall is much cheaper than Netflix.
Outerwall trades at a forward P/E ratio of 9, while Netflix trades at 70. Outerwall’s PEG ratio is a mere 0.5. Outerwall also generates a lot of free cash flow for its investors. Its free cash flow yield (which is the percentage of free cash it generates per share) is an impressive 25%, compared to Netflix’s 10%.
The one area that Netflix is beating out video rental companies like Outerwall is with original content. But for investors looking for an underdog original content play, there’s Starz (NASDAQ: STRZA). It competes with not only Netflix, but also Time Warner Cable (NYSE: TWC)’s HBO.