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TheStreet Open House

8 Dow Stocks Most Likely to Outperform

Stocks in this article: BADDIBMJNJMMMUTXXOM

Note: Total return statistics in the second paragraph were initially misstated -- they have been corrected.

NEW YORK ( TheStreet) -- For long-term investors, navigating the stocks that comprise the Dow Jones Industrial Average has been like walking a minefield.

Had you invested $100 in each of the 10 best performing (active) Dow stocks from September 2000 to September 2010, your principal would have grown to $2,409 -- had you invested in the 10 worst, your principal would have shrunk to $579*. Had you invested across all 30 (active) Dow components, in equal weighting, your annualized return would be a meager 3.15%. But, if you had you avoided the 10 worst performing Dow stocks, your annual return would nearly double to 5.79%.

As the data shows, diversification is a useful tool -- but far more useful for investors that know which stocks to avoid entirely.

In the past we've highlighted the 10 most overpriced Dow stocks (likely to underperform in the long term), and as a corollary, the most attractively valued Dow stocks.

However, just because a stock is attractively valued does not make it a good investment. Five of the 10 Dow stocks in our attractively valued list have delivered negative returns over the last decade -- in many cases, the result of poor management and corporate governance -- not the result of poor performance by the company.

In the immortal words of Benjamin Graham:

"To achieve satisfactory investment results is easier than most people realize; to achieve superior results is harder than it looks."

Nevertheless, we shall attempt to select a small portfolio of Dow stocks intended to outperform the collective future performance of the 20 best-performing Dow components. To screen for candidates, all 30 Dow components were held against the following criteria.

1.) Each stock must have a liability-adjusted cash flow yield** greater than the yield of a 10-year U.S. Treasury note.

The expected rate of return of the equity should exceed the risk-free rate of a Treasury note, preferably, by a ratio of 2-1 (to compensate the owner for business-specific risks).

2.) Each stock must have a return on invested capital greater than 10% (using 10-year historical data).

Return on invested capital measures the success and failures of a company's capital expenditures -- a direct measure of managerial competence. Ten percent is a reasonable minimum figure to ensure that management is spending capital wisely.

3.) Each stock must show a positive total return (including dividends) over the past 10 years.

For an individual investor, 10 years represents a large percentage of his or her "investable lifetime." Ultimately, if the managers of a profitable company are unable to return profits to shareholders in a decade's time, something is wrong. Or, as Benjamin Graham writes in The Intelligent Investor, "poor managements produce poor market prices."

After analyzing the 30 stocks that comprise the Dow Jones Industrial Average, eight issues meet the standards of our established criteria. (It is worth noting that far greater investment opportunities exist outside of the realm of Dow components -- applying the above criteria to a greater universe of stocks will yield many positive surprises.)

*Total return does not include the impact of taxes and trading costs. Total return data only provided for securities currently listed in the Dow Jones Industrial Average. Data provided by Yahoo! Finance via BuyUpside.com.

**LACFY is defined as: 10-Year Average Free Cash Flow / (((Outstanding Shares + Options + Warrants) x (Per Share Price) + (Liabilities)) - (Current Assets - Inventory))

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