Companies find plenty to brag about -- products that are cheaper, faster, tastier, even smarter. One boast you're not likely to hear, though, is: "We're No. 2!" But while firms aren't likely to brag about being the runner-up, experts say it sometimes pays for investors to shoot for second place. "There's a lot of money to be made at No. 2," says Tom Forester, chief investment officer at Forester Capital Management, which manages $300 million.
Call them the No. 2 stocks with the No. 1 returns. In many industries, it's the second-place finisher that winds up paying off best for investors. Stockwise, over the past 10 years, Target has outperformed Wal-Mart, Apple has outmuscled Microsoft, and DuPont has outdone Dow Chemical. Experts say that playing second fiddle has some significant advantages these days. The sluggish recovery has diminished the pricing power that dominant companies enjoy, because consumers are less willing to pay up for the leading brand. That means the top dogs will have to cut prices -- and potentially hurt profits -- to maintain their edge. The second bananas often don't have such problems. "A No. 2 player will be totally geared toward taking share," says Nicholas Bohnsack, sector strategist at Strategas.
Some analysts say it might pay to go with an industry's second-place finisher rather than its top dog.
The No. 2 diversified oil and gas exploration company trades at nine times next year's expected earnings, versus 10 times for No. 1 Exxon. Plus, San Ramon, Calif. based Chevron's dividend currently yields 3.4 percent to Exxon's 2.7 percent.
This Mayfield Village, Ohio, firm is a longtime second to Allstate among publicly traded home, life and auto insurers. But Progressive has new technology -- devices that track drivers' performance and charge them accordingly -- that could boost its share in the auto market, says Meyer Shields, a managing director at Stifel Nicolaus. "I would give them the intellectual edge," Shields says.
The Dallas maker of diapers, toilet paper and other consumer essentials used to be cheaper than No. 1 Procter & Gamble, but now it trades at a slight premium. Still, Kimberly-Clark stands to benefit more from falling commodity costs than its larger rival, which has a more diverse product lineup, says Tom Forester, chief investment officer at Forester Capital Management.
Capital One Financial (COF)
Capital One is the No. 2 pure credit card company, behind American Express. While the two companies' business models aren't identical -- AmEx gets a larger percentage of its sales from processing transactions -- Capital One trades at eight times next year's expected earnings, versus 12 times for AmEx.
Peet's Coffee & Tea (PEET)
Although second to Starbucks in grocery store sales, this Emeryville, Calif., firm has the best growth opportunities of any coffee company, says Nick Setyan, analyst at Wedbush Securities. Setyan estimates that Peet's can grow earnings by as much as 25 percent annually for the next several years.
Some silver-medal advantages hold true in any economy. No. 2 companies tend to be cheaper than the top name in their industry. For example, Chevron trades at nine times next year's expected earnings, versus Exxon's price/earnings ratio of 10. Mark Freeman, chief investment officer at the Westwood Holdings Group, recently sold his Exxon shares and picked up Chevron. What's more, they tend to have higher growth prospects. For No. 1, "it's tough to stay on that wheel, generating these kinds of growth rates," Freeman says. One growth metric he likes is return on invested capital, a measure of how efficiently a company invests money so as to eventually return it to shareholders. Chevron has a return on capital of 16 percent to Exxon's 14 percent. No. 2 firms also can keep their eye on taking out the big dog, while the third-largest firms usually have other issues to combat before going after No. 1. "No. 3 can quickly become a no man's land," Forester says. (Case in point: Few investors expect Sears Holdings to catch up to Wal-Mart or Target anytime soon.)
Often, traders will buy stock in the No. 2 firm if it finally eclipses the leader. "You have very few markets where you have a definite No. 1 that never makes a false step, never stumbles," Bohnsack says. One rare example: the soda business, where Coca-Cola has topped PepsiCo every year since at least 1990, according to "Beverage Digest."
Pete Sorrentino, senior portfolio manager at Huntington Asset Advisors, tries to anticipate this strategy: He'll buy a No. 2 company if the longtime No. 1 starts to look vulnerable. "If the big guy stumbles, then money will flow into No. 2, and you'll get a huge benefit by being there first," Sorrentino says. This strategy works best in markets where stocks are making significant moves in either direction, unlike today's, where stocks are mostly bouncing around in a limited range. No. 2 stocks also tend to be a bit more volatile than the biggest names. That might actually help in today's so-called range-bound market by adding a little extra oomph to investors' portfolios when markets rise, Bohnsack says.
To be sure, investors looking to capitalize on No. 2s can't just buy them at random. "Whether it's a No. 1, No. 2 or No. 10, you want to own companies with an advantage," Freeman says. In today's weak economy, the strongest companies have lots of cash on their balance sheets, Bohnsack says. They're also growing profits by increasing sales, not just by cutting costs. Such a course is all the more necessary, he adds, because companies have already trimmed expenses to the bone.